The Cost of Equity
General Mills
The Capital Asset Pricing Model (CAPM) is the best method of determining the cost of equity for General Mills Inc (NYSE: GIS). Using CAPM calculations, GIS target for December 2014 is $ 50.60 (Reuters, 2013). If this security becomes untenable in one years time, then the option of increasing dividends to boot investor confidence should be explored. The arbitrage pricing theory (APT) is less accurate compared to the CAPM and the dividend growth models. However, CAPM is easy to use. The isolation of the Beta assumptions into a single variable best fit the current state of the company.
General Mills Inc- Cost of Equity
CAPM would estimate the company’s cost of equity as follows
Current cost of equity at 5.96% will be
RE=RF+Beta (RM-RF)
RE =3.15% +0.18 (5%-3.15%)
=3.48%
CAPM Variables and Assumptions
When the above calculations are expanded from the left to the right, new assumptions are introduced by each variable. RF is the risk free rate. In this situation, the 3.15% would use a “zero coupon government bond matching the time horizon of the cash flow being analyzed” (Damodaran, n.d). In the analysis of General Mills, the time horizon being considered is not static, but dynamic. Instead of a 12-month bond, which yields almost zero (0.12%), the coupon on a 30-year Treasury bond represents a better risk-free investment option (Bloomerg, 2013). However, a more contentious variable other than the risk free rate (RF) is Beta, which is the “statistical analysis of past price movements of an individual stock against the market as a whole” (). In this calculation, 0.18 was used. Although Beta is supposed to be a mathematical truth, the assumptions used in the calculations are extremely fluid. For example, several sources were consulted, all which yielded several results. The source of the Beta, Reuters, was used because it was felt to be more credible than the others were. The differences in the Beta values could be based on how each looked at the market as whole. The other variable is the time horizon, the concern is here is whether the entire life should be used to calculate the regression. This will assume that the market is limited to domestic securities of similar risk-adjusted. In this scenario, Beta is a powerful variable as used in the CAPM and the results are highly dependent on how it is selected. In selecting from the available pool, RE could flow from 3.59% and 3.48%.
Lastly, the Capital Asset Pricing Model’s most uncertain assumption is the Rm (expected aggregate market return). This is the expected market performance as a whole in the time being considered. If there were a foolproof method was available, and that could provide an accurate figure for the next one year, there would be no market premium. Indeed, there would be no need for advisors. However, most projections are at the rate of 2% for the economy (Easterling, 2010). This would interfere with expectations of year-over-yea growth well below the historic figures. In addition, Crestmost Research Group have predicted a long-term returns closer to 5%, than the historic projections of 9.75 (Easterling, 2010). While some expectation would enter into these forecasts, uncertainty in the market is still prevalent. For instance, even a small variance of 5.0-9.75% would change Re between 4.34% and 3.48%, when Beta is assumed as 0.18% for both options.
Arbitrage Pricing Theory
This is more precise than the CAPM, although it has more assumptions. This model attempts to redress most of the assumptions under the CAPM. Unlike the CAPM, the APT takes the opinion that investors are unique and motivated by several factors. The CAPM assumes investors are homogeneous. In addition, the investors not only have different risk tolerance, different risk factors are more or less important to each individual investor. In addition, APT acknowledges that the market is comprised of various portfolios, instead of stocks (Easterling, 2010).
Although the risk factors explored above are not clearly defined, several factors can be sued to underscore investor’s interest in risk. These include variations in inflation rate, surprises in gross national product, as well as surprises in investor confidence (Easterling, 2010). These macro economic variables are common in the market as a whole. Indeed, these specific risk components should be captured in many Beta values as there are factors. Two critical choices for the company include crop yields’ effect on raw material, as well as the global demand for staple food products. Although APT might closely model the market and the risk factors affecting General Mills price of equity, the reasoning behind the model remains essentially the same: Beta. Therefore, although APT is more precise than the CAPM, the various combinations of Beta and the forecast of likely changes means that the model is no much better than CAPM. This is because there is the model guarantees no more accuracy. In essence, the model increases the complexity and workload in extrapolating the various Beta factors.
Dividend Growth Model (DGMs)
There are numerous dividend growth models. For instance, there is the Gordon growth model. In addition, there are various dividend discount models as well. All these are similar to the APT, because they need significant projections of future events for them to be accurate. However, unlike the APT, dividend growth models do not have the luxury of past trends on which to base the Beat factor. Dividend growth models operate on the variable of growth itself, which is something that is difficult to generate future valued on.
Dividend growth models work on the assumption that a security only holds value through cash flow generated by dividend payouts (NYU). General Mills has seen an increase in its dividend payouts over the past 6 years by about 10% (Fidelity, 2012). However, it is not easy to provide a forecast for the next 6 years. As can be seen from the recent global financial crisis, volatilities in the economy can have differing effect on securities. For instance, in 2012, General Mill reduced its profit estimates citing weak sales projections (Reuters 2012b). The Gordon growth model is best suited for mature companies, those companies that have a stable growth (NYU 2010). However, although General Mill can be classified in this category, the current volatility in the market share would invalidate any conclusion that the model would offer.
PART II: Specific Company Cost of Equity
CAPM would estimate the cost of equity for the following companies in the following ways;
CAPM would calculate Nike’s current cost of equity at 4.176%:
RE=RF+Beta (RM-RF)
RE = 0.20% + 0.79(4.49% – 0.20%)
RE = 3.59%
This calculation is based on a variable market rate of return of 4.49% and a risk free rate of 0.20%. Using a variable market rate of return may be appropriate in comparing companies, assuming the market rate is risk-adjusted and appropriate to the industry the security operates in.
CAPM would calculate Sony’s current cost of equity at 9.628%:
RE=RF+Beta (RM-RF)
RE = 0.20% + 1.98(6.83% – 0.20%)
RE = 13.33%
CAPM would calculate McDonald Corporation current cost of equity at 1.698%:
RE=RF+Beta (RM-RF)
RE = 0.20% + 0.29(2.94% – 0.20%)
RE = 0.99%
From these calculations, it can be deduced that Sony has the highest cost of equity at 13.33%. This is based on the higher Beta of Sony. In addition, the higher expectation sin the market rate of return also plays an important role in Sony’s performance. Further, the Japanese economic shocks in the last 3 years and the foreign exchange risks might also be a contributing factor.
Conclusion
In conclusion, the various models explored have underlying assumptions in their calculations. It has been shown that the CAPM is the simplest method to use, and that its assumptions are simple. However, although CAPM model relies more on the rear-view to arrive at Beta, it limits its assumptions to empirical data. Further, the CAPM places little emphasis on future growth projections. On the other hand, APT is not suitable because it is adds more burden in determining the Beta value to be sued. Indeed, it is a less effective version of the CAPM. APT has more assumptions compared to CAPM, but these cannot be effectively used in real-world situation. DDM was probably a better model for General Mill. However recent forecast have put doubts on the infinite growth rate that are projected by the model. In the near future, DDM might prove useful for General Mills investors. However, without a good knowledge of the longer-term strategy, it is impractical to estimate the dividend peaks and lows until the market share settles out. In this case, the best course of action for the company in 2014 would be to keep a close eye on its revenues and market share. Every attempt should be made to beat the newly revised forecast. Depending on the cash-on-hand of the company, dividends should be kept steadily.
References
Bloomberg, (2012). Government Bonds. Retrieved from http://www.bloomberg.com/markets/rates-bonds/government-bonds/us/
Damodaran, A. (nd). Picking the Right Projects: Investment Analysis. Retrieved from http://pages.stern.nyu.edu/~adamodar/pdfiles/cfovhds/inv.pdf
Easterling, E. (2010). Waiting for Average. Crestmont Research. Retrieved from http://www.crestmontresearch.com/docs/Stock-Waiting-For-Avg.pdf
Fidelity, (2012). General Mills: Earnings and Dividends. Retrieved from http://eresearch.fidelity.com/eresearch/evaluate/fundamentals/earnings.jhtml?stockspage=dividends&symbols=GIS
Money Terms, (2007). Arbitrage Pricing Theory. Retrieved from http://moneyterms.co.uk/apt/
NYU, (2010). Dividend Discount Models. Retrieved from http://pages.stern.nyu.edu/~adamodar/pdfiles/valn2ed/ch13.pdf C
Reuters, (2013). General Mills, Inc. Financials. Retrieved from http://www.reuters.com/finance/stocks/financialHighlights?symbol=GIS.N
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