Jonathan Burton

Risk Cost of Capital

Expert from Interview with Eugene Fama:

Buton's Question: Finance professor Josef Lakonishok, who believes that human behavior and psychology influence markets, finds fault with the notion that high book-to-market stocks are riskier. He notes that an Internet company like Yahoo! has little book value and a large market capitalization. An underloved utility, in contrast, has a lot of book value and a smaller market cap. By your reasoning, he says, a utility would be more risky than Yahoo! because it has a higher book-to-market value. How would you answer that?

Fama's Answer: You may think that’s wrong, but the reality is it’s all coming out of the price. People are willing to pay more for a dollar of whatever Yahoo! owns than they are for a utility. Which, if you turn it over, says they’re willing to hold Yahoo! at a lower expected return.

You no longer think about risk in terms of variance alone. If you do, that takes you right back to the Capital Asset Pricing Model. You want to think about risk in more expansive ways. The cost of capital of a distressed company is higher than the cost of capital of a growth company like Yahoo! Distressed companies pay more [with more of their book value] through the lower stock price, and that’s the way they generate a higher return.

IFA Note: Historically, a higher cost of capital for the equity seller, translates to a higher expected return for the provider of capital (cash.) A lower cost of capital for the seller of the equity translates to a lower expected return for the buyer (provider of the capital.) The trade of equity for cash is the heart of capitalism!

Source: www.ia-mag.com