Risk Needs to be Better Understood

May 25th, 2010 by hackel Leave a reply »

Cost of equity capital has risen for three months in a row, almost on weekly basis. And this week, cost of equity, for the S&P 500 companies, has risen to over 9%, the first time it has crossed this mark in over a year.

What has been the reason for the increase?

According to the CT Capital credit model, and outlined in my upcoming text, “Security Valuation and Risk Analysis,” McGraw-Hill, rise in yield spreads, sovereign risk, cash versus the effective rate, and volatility measures of several fundamental metrics, have led the way.

But they are not the only metrics which pinpoint increases in fundamental security risk.

Most have to do with credit health, such as rollover risk and the ability to repay all debt from a consistent cash flow stream when those cash flows are adjusted to normalized conditions. For example, while cash flow from operating activities and free cash flow have been increasing, when adjusting for normalized levels compared to sales and balance sheet, the rise is subpar, especially when taking into account spending plans.

Most entities which have announced large rises in cash flows plan to have such resources consumed thru additional spending agendas, which are not necessary, given their current sales level. The lessons they have learned from the financial crisis have not sticked. Other enterprises are once again buying back their stock, which, in our opinion, is almost always a waste of corporate assets.

Other credit measures are generally in line with normal conditions, although for certain firms,  cost of capital is indicating a risk to cash flows not currently assumed. Many firms, for example, will see large amounts of cash needed to fund both domestic and foreign benefit plans.

With the multiple on the S&P now suggesting stocks are near fair value ( 2% over-valued), the rise to cost of capital needs to be better understood.

Kenneth S.Hackel, C.F.A


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