“expectedreturn.”Wearguethatriskinaninvestmenthasto
beperceivedthroughtheeyesofinvestorsinthefirm.Since
publiclytradedfirmshavethousandsofinvestors,oftenwith
verydifferentperspectives,wewillgofurther.Wewillassert
thatriskhastobemeasuredfromtheperspectiveofnotjust
anyinvestorinthestock,butofthemarginalinvestor,defined
tobetheinvestormostlikelytobetradingonthestockatany
given point in time.
COST OF EQUITY
Thecost ofequityis akey ingredientof everydiscounted
cashflowmodel. Itisdifficulttoestimatebecauseitisan
implicitcostandcanvarywidelyacrossdifferentinvestorsin
thesamecompany.Inthissection,webeginbyexaminingthe
intuitive basis for thecost of equity and we then look at
different ways of estimating this cost of equity.
Intuitive Basis
AswenotedinChapter1,thecostofequityiswhatinvestors
intheequityinabusinessexpecttomakeontheirinvestment.
Thisdoesgiverisetotwoproblems.Thefirstisthat,unlike
theinterestrateondebt,thecostisanimplicitcostandcannot
be directlyobserved. Thesecond isthat thisexpected rate
neednot be the samefor all equityinvestors in the same
company. Different investors may very well see different
degreesofriskinthesameinvestmentanddemanddifferent
ratesof return,given theirrisk aversion.The challengein
valuationisthereforetwofold.Thefirsttaskistomakethe
implicit cost intoan explicitcost by readingthe minds of
equity investors in an investment. The second and more
dauntingtaskis tothencomeupwitha rateofreturnthat