Posted: February 26th, 2023

cost of capital

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3/2/2021 How the parting of two market forces helped spur the equity rally | Financial Times

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Uncertainty created in the wake of the pandemic has been reflected in stock markets with a rise in volatility © AP

Michael Mauboussin FEBRUARY 9 2021

The writer is a researcher at Morgan Stanley Investment Management

The year 2020 will forever be associated with Covid-19 and the ills it caused to people
and economies around the world.

The outbreak of the pandemic led to the greatest contraction in global economic
activity in decades and a precipitous fall in stock markets. More surprising to most
was the extent of the sharp rally from March lows.

The interplay of two forces that drive valuations, the cost of capital and the volatility
of markets, might explain some of that counterintuitive behaviour.

The cost of capital represents the return investors demand for owning a security and
therefore determines a company’s cost of debt and equity funding. Volatility in
markets captures uncertainty about the future.

Opinion Markets Insight

How the parting of two market forces helped spur the equity rally

MICHAEL MAUBOUSSIN

Volatility boosts value of companies with options to invest in future projects

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3/2/2021 How the parting of two market forces helped spur the equity rally | Financial Times

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Quite sensibly, the cost of capital and volatility almost always move in lockstep
because investors require a higher expected return when the world looks riskier. But
in 2020, the cost of capital and volatility went in opposite directions.

When the price of many stocks and bonds plunged, central bankers referred to a
playbook created during the 2008 financial crisis. Prescribed actions included
lowering interest rates, purchasing securities on the open market, lending to
businesses on favourable terms and providing households with money to ease their
burdens.

These actions had the effect of lowering the cost of capital. The cost of equity
component of this is commonly calculated as the sum of a risk-free rate of return and
the equity risk premium (the extra return investors require for owning stocks).

The yield on the US 10-year Treasury note is a proxy for the risk-free rate and went
from 1.9 per cent at the beginning of 2020 to 0.9 per cent at the end. Aswath
Damodaran, a professor and valuation expert, estimates that the equity risk premium
dropped from 5.2 to 4.7 per cent over the same period as the rebound in stock prices
implied lower future returns. The yields on corporate bonds followed a similar
trajectory.

3/2/2021 How the parting of two market forces helped spur the equity rally | Financial Times

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These figures imply that the cost of equity
declined from 7.1 to 5.6 per cent during the
year. When used in valuation calculations,
this boosts the current worth of expected
future earnings of companies as the future
income stream is discounted at a lower rate.

Companies therefore received a richer
valuation on greater current or prospective
earnings. Companies that gained from trends

arising from the pandemic, such as those that enabled working from home,
particularly benefited.

However, while the actions of the central banks relieved financial pain, they did little
to dissipate uncertainty. Open questions include the timing and strength of the
economic recovery, which businesses will be the ultimate winners and losers, and the
degree to which consumer behaviour has changed permanently. 

The uncertainty has been reflected in stock markets with a rise in volatility. This is
captured by the Cboe volatility index, or Vix. The Vix started 2020 at about 14 but
averaged 30 for the full year. The ratio of the Vix to the cost of equity averaged around
two from 2016-2019 but soared to five in 2020. This matters because volatility is a
primary driver of option value.

An option is the right, but not the obligation, to do something. Financial options have
been around for a very long time. In recent decades, economists have also developed
the concept of real options. These represent the value of a company’s right to make
real investments in projects such as expansion into a new line of business. 

While the actions of the
central banks relieved
financial pain, they did
little to dissipate
uncertainty

3/2/2021 How the parting of two market forces helped spur the equity rally | Financial Times

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High volatility means the potential worth of projects falls in a wide range. There’s no
obligation to act on an option if value is low, but there is a right to act if value is high.
Certain businesses are rich with real options. Think of Amazon 20 years ago.

In 2020, companies with real options had a valuation boost for their current
operations because of a fall in the cost of capital and a gain in their real options
because of an increase in volatility. These observations are also consistent with the
performance of convertible bonds, securities that combine a stream of cash flows and
an option to convert into equity. The Bloomberg Barclays US Convertibles Liquid
Bond Index rose 54 per cent in 2020. 

This might help explain some of the large stock price movements in the past year,
particularly in the tech sector. The cost of capital and volatility are likely to converge
as we pass through this episode. But the pandemic caused actions and reactions with
remarkable implications for valuation.

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