Much of the current stock market volatility is the result of security analyst poor understanding of risk. When security analysts appraise asset values, they discount the expected cash flows. Unfortunately, the rate they use is based on a measure of volatility (the beta) and not on fundamental measures, such as cash flow and credit strength. Because the cost of capital (this discount rate) has such as strong effect on fair value, it is resulting in unprecedented price swings.
Investors Need To Better Understand Risk
If it seems like200+ point swings in the Dow Industrials are a daily occurrence, it’s because it is. Over the past three months, in fact, the Dow has fluctuated in a 15% trading range and the S&P in a 16.5% range. The financial press, following the lead of investment strategists, has laid blame for these large price movements alternately on euro weakness, possible new legislation here in the U.S, trading restrictions in Germany, and various events in Greece, China, Turkey, Spain, and elsewhere. When blame is placed on alternating events, stock volatility is normally a result of other factors. The real culprit, I am certain, is investors, in general, do not have a proper understanding of security risk. That being the case, fear often engulfs analytical judgment as investors become unsure how to properly measure the expected returns along various asset classes.
When was the last time you heard a securities analyst or investment strategist remark? “Company X had an increase (or decrease) in risk during the quarter,” instead of they beat (or did not) earnings or sales estimates. Risk and reward cannot be solely judged by income statement results.
In truth, companies prosper for one reason: they can generate cash returns above their cost of capital. Simply put, that means the rate of return (measured by the free cash flow) on the assets of the enterprise are in excess of that demanded by creditors and equity holders. The greater and more consistent the margin between cost of capital and the return on invested capital, the safer the investment. Cost of capital, whether it is for equity, debt or hybrid securities are a true measure of risk.
Yet, today, security analysts are taught to gauge cost of capital by a measure of volatility, known as the beta coefficient, which is the security price change related to the change in an index, such as the S&P 500. It is a variable of what they were taught by academicians in business schools, as the capital asset pricing model (CAPM). This popular method of risk assessment is wrong, and is in good part, responsible for the current volatility we are seeing. Cost of capital can only be appropriately measured by the possible impairment to the free cash flows and its relationship to cost of capital. If an investor were certain as to an asset’s free cash flows, the determination of fair value would be considerably easier. But even with absolute certainly, fair value could not be made with perfect precision as economic circumstances change, such as the rate of inflation or tax rates. Those issues aside, a financial analyst should only be concerned with stock volatility if they, or the company they were following, were in the market to buy or sell securities. To the long-term holder, the cost of capital should not be determined by the swings in the stock price. The reliance on stock volatility in the placement of a cost of capital rate is so ingrained in Wall Street (sell-side) analyst research reports that it renders a high percentage of those reports useless. Security analysts are then forced to find an accounting yardstick such as price/earnings or price/book to back up their investment ratings. However, accounting ratios do not often reflect underlying financial risk, cash flows, competitive market position, possible loss of a patent or supplier, financial structure or resources available to the enterprise, which do in fact help determine cost of capital. Accounting concepts are often not a measure of cash that could be used to repay debt or distribute wealth to shareholders.
One never hears of successful builders of businesses mention beta, or other academic statistical risk tools. They talk about products, customers, risk and cash. They talk about growth rates in free cash flow, taxes, and stability. Consider the following, and ask if beta or fundamentals should drive their stock prices:
Georgia Gulf has a beta of just 0.3, indicative of a low risk entity, yet it is rated just “B” by Standard & Poor’s (S&P). A “B” rating by S&P is defined as, among other things, as having greater vulnerability to default than other speculative grade debt that could lead to inadequate capacity or meet timely interest and principal payments.
Comcast is rated BBB (“adverse economic conditions could lead to default”), yet analysts may consider it to have a lower cost of equity capital than 3M, due to its having less stock volatility as reflected by its beta coefficient. A “BBB” rating is regarded by S&P as having predominantly speculative characteristics. 3M is rated AA-, which S&P indicates as having a very strong capacity to repay interest and principal.
Hundreds of companies have low betas, and are thusly accorded a low cost of equity capital- yet they can’t pay their bills! Hundreds of other firms are erroneously accorded a high cost of capital, yet are strong and consistent producers of cash flow and do so with just moderate financial leverage. True, many hundreds of companies are in bankruptcy, technical default or a stiff wind away from that status, yet have a lower cost of capital, because of their stock trading patterns, than say, a Microsoft, or other deserved AAA rated entity.
Cost of equity as calculated via the misty lens of stock volatility has been followed by consultants who received their M.B. A.’s at university’s teaching this faulty gospel. These leading management consultants, in turn, have advised Board of Directors these methodologies are the most appropriate approaches, and since they are taught at leading universities, have not been questioned.
Companies with unpredictable sales, volatile tax rates, upcoming litigation, are not producing positive cash flows, have recently undergone a large business combination, risky foreign exposure, are but a few of the metrics analysts must look at to determine cost of capital, hence risk. Stock swings may not be associated with such factors.
The following table illustrates the difference to cost of equity capital when based on a the credit model employed at CT Capital versus that used by Wall Street analysts basing risk off of the capital asset pricing model. Given a 1% change in the cost of equity can change fair value by a third, it is no wonder stocks are as volatile as they currently are.
Company CAPM Credit Model
Toyota 7.5% 9.7%
Rite Aid 6.8% 18.5%
IBM 10.0% 8.4%
Unless then, investors begin to adopt more suitable risk metrics based on what is important to owners of capital- their ability to earn a cash based return in excess of cost of capital using fundamental metrics, and not stock volatility, the latter often the result of fear, greed, institutional trading or rumor, expect stocks to continue to show aggressive trading swings, the kind that tend to scare most small investors away from the stock market.