Cost of Capital: Applications and Examples, + Website, 5th Edition

CHAPTER 18

Other Methods of Estimating the Cost of Equity Capital¹

Introduction

Fama-French Three-factor Model

Comparing Models

Arbitrage Pricing Theory

Background of APT Model

Market-derived Capital Pricing Model

Yield Spread Model

Implied Cost of Equity Capital

The DCF Method

Residual Income Method

Comparing Implied Cost of Equity to Models

Using Analyst's Forecasts

Sources of Information

Summary

Additional Reading

INTRODUCTION

The pure capital asset pricing model (CAPM) (like Markowitz's portfolio model, upon which CAPM was based) provides fundamental insights about risk and return. However, while providing a framework to fundamental concepts of asset pricing and portfolio theory, pure CAPM is fraught with empirical problems, as we discussed in Chapter 13. While simple to understand and easy to apply, the empirical record of pure CAPM is poor.²

Because of that poor record, a number of alternative models have been developed that have proven to better explain differences in rates of return among stocks of companies. Many of these models are multifactor models; they include risk factors other than simply beta that have been shown to be priced by the market. For example, in Chapter 10 we introduced the modified CAPM, which adds a size premium and a company-specific risk premium to the pure CAPM.

Generally, the multifactor models begin with a risk-free rate of return and add one or more factors based on the risks of the investment.

As an alternative to using a model, you can also ...