The cost of equity is an essential input in the financial models used by analysts to determine the fair value of a company. It is defined as the return a firm theoretically pays to its shareholders, in order to compensate for the risk they undertake by investing their capital.

In the capital structure of a company, equity is ranked the lowest in terms of seniority, meaning that equity holders have the lowest claim on the assets of a company.

Therefore, in theory equity holders would expect a higher return than more senior providers of capital, such as bank financing or bondholders. Determining the exact price tag that equity investors should command has been a topical discussion for decades, with numerous empirical studies held over different time horizons.

Several theories and methods at attempting to reliably determine this have been propositioned. A method that has stuck, and is now the cornerstone of modern portfolio theory, is the use of the capital asset pricing model, commonly referred to as the CAPM.

The CAPM method uses the statistical variations of the share price of a publicly traded equity, compared to the general market (typically a proxy is used such as the S&P 500) to determine the volatility and implied risk of the equity.

The critical underpinnings, and commonly cited drawbacks to this approach is the use of proxies for the global market return, the assumption of perfect markets that correctly reflect all known information, and related to the previous point, adequate liquidity whereby investors may enter or exit investments at will and no cost. In the real world, and particularly applicable to the companies listed on the Malta Stock Exchange, the reality is quite different.

Most companies are rather small, trade erratically, and are subject to reporting biases due a general prevalence of opacity in the way some companies are really performing. For this reason and more, the issue of determining the cost of equity is one which remains elusive, with several interpretations being used by investment practitioners.

One of the approaches that is seldom cited is the market-implied cost of equity. This approach determines what the general market is “pricing-in” as a cost of equity and applying it to the subject companies. It is a direct observation, manipulating the dividend-based formula for determining the value of a company, called the Gordon Growth Model (GGM), and backing out the cost of equity.

Some critical assumptions underpin this approach, namely a calculation of the future growth in dividends, and that the companies used, on average, are correctly priced. Given the relatively small number of companies listed on the Malta Stock Exchange, the sample-sizes are not ideal and admittedly may be biased.

Nonetheless, the results from this exercise were interesting. The table below provides an output on the local market-implied cost of equity (Ke) based on the last twelve-month financials of 2019 and the closing prices as at 28/10/2019.

The dividend utilised in the GGM is based on each company’s sustainable growth rate (return on common equity multiplied by the retention ratio), with an assumed long-term dividend growth rate of 2%. This approach is only applicable to mature dividend paying companies.

HSBC Bank Malta plc’s net dividend yield is based on the total net dividend distributed for FY 2018. The net dividend of both, GO plc and Mapfre Middlesea p.l.c excludes one-off dividends distributed during 2019. Malita Investments plc.’s earnings exclude fair value gains on property.

As illustrated, the average implied cost of equity for the local mature and dividend-paying companies is of 4.7%. The dividend growth rate is a key input to this exercise, and directly increases the cost of equity.

Across various arrays of financial literature used by local practitioners, which often use international proxies and peer analysis, the cost of equity used in their models generally varies between 8-10% in today’s market.

The outcome from this exercise leaves us with two conundrums; should a lower cost of equity be used to reflect what the market is really discounting or is the market generally expecting dividends to grow at around 5-7% per annum, validating the 8-10% cost of equity range that one would logically expect from a mature company?

In our opinion the answer lies somewhere in between the two arguments.

As yields have compressed to unnatural levels, dividend yields have also generally compressed, increasing valuations and lowering the implied cost of equity.

We believe that this is not necessarily a function of an expectation of aggressive dividend growth expectations or that indeed the riskiness of these equities has suddenly significantly decreased, but a by-product of an ultra-low yield environment, which is here to stay for the near future.

This article was issued by Simon Psaila, Capital Markets and Research Manager, and Rowen Bonello, Financial Analyst at Calamatta Cuschieri. For more information visit, www.cc.com.mt. The information, view and opinions provided in this article are being provided solely for educational and informational purposes and should not be construed as investment advice, advice concerning particular investments or investment decisions, or tax or legal advice.