In this article, we are going to cover the basics of the cost of capital, valuation, inflation, and the stock market. In the end, you should be prepared to understand some of the stock market’s movements when the official CPI (Consumer Price Index) is released and how it can impact your investments.
If you want to have a broader perspective on the global inflation outlook and what is pushing the CPI up, then you can take a look on this article.
The birth of portfolio selection
Observation, Experience and Performance
Do you remember that one dollar bill that you forgot in your pocket during the whole year? This one…
You didn’t pay for anything, but the act of forgetting the dollar bill in your pocket had a hidden cost. This is called cost of capital. You can understand this as what you could have earned in the market by investing the one dollar bill in fixed income and stocks. Basically it’s this.
The theoretical concepts of the cost of capital and portfolio selection rely on a mathematical model that estimates the return of an investment based on its riskiness relative to the rest of the market. This model is known as the Capital Asset Pricing Model (CAPM) and it was developed by Harry Markowitz in 1952. If you want to dive deeper (much deeper btw), you can read it here.
It’s important to point out some of Markowitz’s main ideas that, despite the criticism by many analysts today, continue to be valid in some way even after 70 years:
‘”The process of selection a portfolio may be divided into two stages. The first stage starts with observation and experience and ends with beliefs about the future performances of available securities (…) This paper is concerned with the second stage.”
The bolded words are very important. Let’s take a further look:
- Observation and experience represent the analyst’s ability to forecast the company’s results and the stock market price;
- The future performance of available securities represents how stock market prices will behave in relation to every news around us, especially the company’s results.
The Nominal Cost of Capital
Calculating the cost of capital using all of the academic strictness isn’t easy, but we will do it in a simpler way. Let’s start presenting the CAPM formula:
- Rf: There can’t be anything that is “risk-free” in the market, right? Everything has a risk. BUT, this variable represents the possibility of investing that one dollar bill you forget in your pocket in Government bonds. Why? Because they are considered the safest options. If the government doesn’t have money to pay you, at least he can print more money to do it. Companies can’t do that (yet). This variable is commonly related to the United States 10-year Government Bond (T-Bond). You can check the rates here. Let’s round the rate for 3.5%;
- Rm: It represents the expected return of a hypothetical market portfolio during a certain period of time (normally is 5 to 10 years). Let’s take the “market portfolio” as the S&P 500 annualized performance on the last 5 years (7.5%);
- Beta: It measures the volatility of a security or portfolio in relation to the whole market. If the market goes up 1%, but the portfolio goes up 2%, then the Beta will be equal to 2. If the market goes down 1%, but the portfolio goes down 0.5%, then the Beta will equal 0.5. Let’s use 1.2 here;
- Equity Market Premium: This is simply the difference (premium) that an investor will ask to take the additional risk to invest in the stock market aiming for higher rewards. In our example, this the premium will be 4% (7,5% – 3,5%).
What can we do now? Simple. Let’s combine all of them together:
CAPM = 3.5% + 1.2 (4%) = 8.3%
What does 8.3% mean after all? It means that you could have invested that one dollar bill and gotten about 8 cents after one year. You should have $1.083. The problem is that this is a nominal rate and it doesn’t consider inflation.
The Real Cost of Capital
Here is where inflation comes in. It makes no sense for an investor to disconsider inflation and evaluates assets using the nominal cost of capital. You have to apply this simple formula in order to calculate the real cost of capital:
Here is what you get when you adjust your nominal cost of capital:
If the expected inflation is 8%, then your real cost of capital is only 0.28%. This means that if the investor don’t consider inflation, he will be getting Inflation + 0.28%. This is why the investors will add the inflation to the nominal cost of capital and make it real.
How can we adjust the nominal cost of capital, so the real rate will always be 8.3%? Easy. Check the column “Adjusted”. As inflation goes up, so does the nominal cost of capital.
Valuation
Valuation it’s an art and I’ll not go through many concepts. All I’ll say is that the cost of capital will be used as a metric to discount a future cash flow in order to decide if the stock is overvalued or undervalued.
It’s important to say that the companies’ cash flows react differently to inflation. It’s expected that companies on regulated markets (e.g.: Public Utilities) have contractual rights to adjust their revenues in relation to inflation. The same doesn’t happen with a regular retailers.
Take a look at NextEra Energy (NEE) total revenues:
Inflation will have a direct impact in valuation. Consider the following hypothetical cash flow:
The yellow mark denotes the price. If your cost of capital is 8.3%, how much would you be willing to pay for this cash flow across many different inflation scenarios?
If you are in doubt about how to calculate the numbers in the “Price” column, don’t be. Here is the example for the first price of $17,21.
Conclusion
We could have diven much deeper in this article. We could have shown how to calculate the Beta, and the market return and do a fully valuation for a company traded in the stock market. But none of this was the main purpose of this article.
We have shown a bit of the portfolio selection theory and how the cost of capital works. The difference between the nominal/real rates and how investors intuitively act in the stock market to discount a higher expectation of inflation.
Inflation drives higher interest rates that pressure the company’s cash flows and impact the economy as a whole. Investors (especially the institutional investors) will adjust the “fair price” of any asset in relation to a new future.
You may not be studious in Finance and Investment field, but you may be willing to (or already is) invest (ing). Being aware of how the market works is an important first step ahead.