Cost of Capital Analyses presented by: Philip S. Borba, Ph.D. - - PowerPoint PPT Presentation

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Cost of Capital Analyses presented by: Philip S. Borba, Ph.D. - - PowerPoint PPT Presentation

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Cost of Capital Analyses presented by: Philip S. Borba, Ph.D. Milliman, Inc. New York, NY March 20, 2012 Casualty Actuarial Society, Ratemaking & Product Management Seminar, Session: Practitioners Guide to Cost of Capital/Profit

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Cost of Capital Analyses

presented by: Philip S. Borba, Ph.D. Milliman, Inc. New York, NY March 20, 2012

Casualty Actuarial Society, Ratemaking & Product Management Seminar, Session: “Practitioner’s Guide to Cost of Capital/Profit Provisions,” Philadelphia, PA

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The Casualty Actuarial Society is committed to adhering strictly to the letter and spirit of the antitrust laws. Seminars conducted under the auspices of the CAS are designed solely to provide a forum for the expression of various points of view on topics described in the programs or agendas for such meetings. Under no circumstances shall CAS seminars be used as a means for competing companies or firms to reach any understanding – expressed or implied – that restricts competition or in any way impairs the ability of members to exercise independent business judgment regarding matters affecting competition. It is the responsibility of all seminar participants to be aware

  • f antitrust regulations, to prevent any written or verbal

discussions that appear to violate these laws, and to adhere in every respect to the CAS antitrust compliance policy.

Casualty Actuarial Society -- Antitrust Notice

March 20, 2012 2

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3 March 20, 2012

The Rate of Return Measure: Starting Considerations

The economic rate of return on equity capital is the proper rate of return measure:

– Theory: standard corporate finance textbooks present the economic return on equity as the proper measure for evaluating investment

  • pportunities

– Pragmatism: it is a measure of profitability used by insurance

  • regulators. Regulators also use statutory surplus to measure returns.

For regulated entities, both economic theory and judicial rulings have validated the opportunity cost of equity capital to be the reasonable economic rate of return on equity.

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4

Overview

Models for Estimating the Cost of Capital

  • Discounted Cash Flow Analysis
  • Capital Asset Pricing Model
  • Fama-French 3-Factor Model (FF3FM)

Estimation Considerations

  • Discounted Cash Flow Analysis
  • Capital Asset Pricing Model
  • Fama-French 3-Factor Model (FF3FM)

Results

  • Results from DCF and CAPM
  • High Correlation Between Cost of Capital and US Treasury Interest

Rates

  • Summary – Two Time Periods Covered 1989-2008
  • Summary – Results for 2008-present

March 20, 2012

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5

Limitations

Results in this presentation are for demonstration purposes only. Data are from public sources and have been reviewed for consistency but have not been audited. The analyses and results statistics are intended to demonstrate the principles of cost of capital estimation methodologies. Presented methodologies and results may not be appropriate for all applications in the property-casualty insurance industry. Users are strongly advised to review the underlying methodology and data sources when performing a cost of capital estimation.

March 20, 2012

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6

Cost of Capital: Models for Estimating Cost of Capital (COK)

Presentation presents two commonly used models with long histories in regulatory proceedings and one model with a shorter history. 1. Discounted Cash Flow (DCF)

– Most commonly used methodology in utilities regulation and one of the most commonly used in insurance regulation.

2. Capital Asset Pricing Model (CAPM)

– The modern academic model of risk pricing. – One of the most commonly used models in utilities and insurance regulation.

3. Fama-French 3-Factor Model (FF3FM)

– Extension of CAPM and APT models.

March 20, 2012

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7

Discounted Cash Flow Analysis -- Concepts

  • The DCF analysis produces the interest rate that equates the

net present value of future earnings from an investment to the cost of the investment.

  • In practice, the DCF cost of capital is the sum of the current

dividend yield plus the expected growth rate in dividends.

  • A commonly used expression for the DCF model:
  • COK = D1 + g
  • where D1 is the current dividend yield
  • g is the expected growth in dividends

March 20, 2012

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8

Discounted Cash Flow Analysis (DCF): Estimation

i i

r Di

∑

∞ =

+

1

) 1 /(

Price of stock equals present value of future cash flows If D grows at constant annual rate, g, then ( ) ( ) ( ) g P g D r r g D r g D P

  • +

+ = + + + + + + = 1 ...... ) 1 ( 1 1 1

2 2

Price of stock equals present value of future cash flows If D grows at constant annual rate, g, then

March 20, 2012

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9

Capital Asset Pricing Model -- Concepts

  • Under the CAPM, investors expect to be compensated for the

risk of an investment opportunity – the greater the risk, the higher the return required by the investor.

  • The starting point is a “risk-free” investment – a US Treasury

security.

  • The “risk premium” is the average difference between the return
  • n the market and the risk-free rate.
  • The “relative risk” - β – measures the volatility of the investment’s

return compared to the return on the equity market.

March 20, 2012

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10

Capital Asset Pricing Model -- Estimation

  • Common expression for the CAPM:
  • COK = rf + β (rm – rf )
  • where
  • Rf is the risk-free return (US Treasury)
  • β is the relative risk measure
  • (rm – rf ) is the difference between the return on equity investments

and the risk-free return

March 20, 2012

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Fama-French 3-Factor Model -- Concepts

  • Fama- French findings: CAPM does not adequately explain

cross-sectional variation in average stock returns

  • Fama-French developed a 3-factor model:
  • Risk-free rate continues to be starting reference point
  • CAPM retained for systematic risk
  • Risk-premium added for size effect (smaller companies have

higher capital costs)

  • Risk-premium for book-to-market ratio (high-ratio companies have

higher capital costs)

March 20, 2012

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12

Fama-French 3-Factor Model -- Estimation

  • Starting expression for the FF3FM:
  • COK = rf + βmrpm + βssrpss + βfd rpfd
  • where
  • rf is the risk-free return (US Treasury)
  • β is the relative risk measure
  • rp refers to a risk premium
  • “m” refers to the market
  • “ss” refers to small stock
  • “fd” refers to financial distress

March 20, 2012

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13

Estimation Considerations – Present Analyses

  • DCF and CAPM are standard approaches described in

corporate finance texts and frequently used in regulatory proceedings to estimate the models. FF3FM is less used in regulatory proceedings.

  • Used data for a sample of property-casualty insurers.
  • Relied on data from widely used, publicly available data

sources (eg., Federal Reserve, Value Line Investment Survey, CompuStat).

March 20, 2012

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14

Estimation Considerations – Judgments and Selections

  • Each cost of capital estimation methodology requires careful

judgments and selections concerning:

Covered period

– Such as monthly, quarterly, annual

Methodology

– Example: choice of growth factors in DCF

Included companies Data sources Smoothing strategies

  • Some of the points in these judgments and selections are

illustrated or discussed later in this presentation.

March 20, 2012

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Cost of Capital: Discounted Cash Flow Analysis -- Estimation

  • Expression for the cost of capital using the DCF model:
  • COK = D1 + g, where
  • D1 is the current dividend yield
  • g is the expected growth in dividends
  • An illustration using data for 2008.
  • Data as of July 2008
  • 22 property-casualty insurance companies
  • Source: Value Line Investment Survey
  • Estimated cost of capital for July 2008:
  • Current dividend yield = 2.2%
  • Expected growth in dividends = 10.66%
  • Estimated cost of capital = 12.86%

March 20, 2012

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Cost of Capital: Capital Asset Pricing Model -- Estimation

  • Expression for the cost of capital using the CAPM:
  • COK = rf + β (rm – rf ), where
  • rf is the risk-free return (US Treasury)
  • β is the relative risk measure
  • (rm – rf ) is the difference between the return on equities and the risk-free

return

  • An illustration using data for 2008:
  • Data as of July 2008
  • Sources: Value Line, Federal Reserve, and Ibbotson
  • Estimated cost of capital for July 2008 (for short-term equity-risk premium):
  • Risk-free investment (short-term): 1.52%
  • B = 0.93
  • (rm – rf ) = 8.5%
  • Estimated cost of capital = 1.52% + 0.93 x 8.5% = 9.38%

March 20, 2012

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Cost of Capital: Results from DCF and CAPM

March 20, 2012

Year DCF CAPM Cost of Capital 1989 15.44 16.26 15.85 1990 16.17 16.19 16.18 1991 16.04 14.80 15.42 1992 15.18 13.80 14.49 1993 14.90 12.64 13.77 1994 13.62 13.79 13.70 1995 13.44 13.75 13.59 1996 12.83 13.67 13.25 1997 12.31 13.48 12.90 1998 12.97 13.18 13.07 1999 11.94 13.53 12.73 2000 11.79 14.50 13.14 2001 11.42 12.54 11.98 2002 10.10 11.58 10.84 2003 9.08 10.22 9.65 2004 9.76 10.92 10.34 2005 10.18 11.17 10.67 2006 10.94 12.64 11.79 2007 10.96 12.35 11.66 2008 12.86 10.21 11.53

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Cost of Capital: Summary

March 20, 2012

8 9 10 11 12 13 14 15 16 17 1989 1992 1994 1996 1998 2000 2002 2004 2006 2008 DCF CAPM Average

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Cost of Capital: High Correlation Between Cost of Capital and US Treasury Interest Rates

March 20, 2012

2 4 6 8 10 12 14 16 18 1989 1992 1994 1996 1998 2000 2002 2004 2006 2008 Average COK Avg Interest Rate

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Cost of Capital: Summary – Two Time Periods

Period Cost of Capital Average Interest Rate 1989 – 2000 14.0 6.4 2001 – 2008 11.1 4.0 Difference

  • 2.9
  • 2.4

For each year between 1989 and 2000:

– Cost of Capital higher than 12% – Average interest rate on US securities 5% or higher

For each year between 2001 and 2008:

– Cost of Capital lower than 12% – Average interest rate on US securities 5% or lower

March 20, 2012

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Cost of Capital: January 2008-present

Expanded the number of property-casualty companies captured in the analyses:

– Expansion includes companies from Value Line Small and Mid-Cap companies, CompuStat, and Yahoo – Number of companies increased from approximately 22 to approximately 90

Two methodologies:

– DCF – CAPM

Volatile financial markets

March 20, 2012

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22

US Treasury Yields – 1990-2011

US Treasury yields can be considered a reference point in cost

  • f capital estimations.

– US Treasury yields provide a “risk-free” benchmark. – Explicitly used in CAPM, implicit in DCF.

Over the 1990-2011 period (points illustrated in following charts):

– The position of US Treasury Yield curves has been pushed down. – For all maturities, US Treasury yields have decreased. – Yield spreads are volatile and tied to the position in the economic cycle.

March 20, 2012

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US Treasury Yields – 1990-2011

The position of US Treasury Yield curves has been pushed down over the 1990-2011 period

March 20, 2012

1 2 3 4 5 6 7 8 9 5 10 15 20 25 30

1990 1991 1992 1993 1998 2007 2008 2009 2010 2011

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US Treasury Yields – 1990-2011

For all maturities, US Treasury yields have decreased

– Yields most volatile for 3-month maturities

March 20, 2012

0.00 1.00 2.00 3.00 4.00 5.00 6.00 7.00 8.00 9.00 3-mo 5-yr 10-yr 30-yr

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US Treasury Yields – 1990-2011

Yield spreads are volatile and tied to the position in the economic cycle.

– Size of spread related to volatility in short-term Treasury yields.

March 20, 2012

  • 0.50

0.00 0.50 1.00 1.50 2.00 2.50 3.00 3.50 4.00 4.50 2-yr v. 3-mo 5-yr v. 3-mo 10-yr v. 3-mo 30-yr v. 3-mo

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Cost of Capital: Discounted Cash Flow Analysis -- Estimation

  • An illustration using data for January 2012.
  • Data as of January 2012
  • 89 property-casualty insurance companies
  • Principal sources: Value Line Investment Survey, CompuStat, Yahoo
  • Estimated cost of capital for January 2012:
  • Current dividend yield = 2.25%
  • Expected growth in dividends = 7.93%
  • Estimated cost of capital = 10.18%

March 20, 2012

Discounted Cash Flow Analysis 10-year historical 5-year historical 5-year future Average Current Dividend Yield

  • 2.25

Dividends per Share 8.11 5.29 7.12 6.84 Earnings per Share 5.25 2.32 9.68 5.75 Average growth rate

  • 6.29

Fundamental Analysis

  • 9.56

Dividend Growth Rate

  • 7.93

Estimated Cost of Capital

  • 10.18
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Cost of Capital: Capital Asset Pricing Model – Estimation

  • An illustration using data for January 2012.
  • Data as of January 2012
  • 89 property-casualty insurance companies
  • Principal sources: Value Line Investment Survey, CompuStat, Ibbotson, Fed Reserve
  • Estimated cost of capital for January 2012:
  • Beta = 1.03
  • Estimated cost of capital = 8.84%

March 20, 2012

CAPM Analysis Risk-Free Return Beta / Risk Premium Estimated Cost

  • f Capital

Beta

  • 1.03
  • Short term

0.01 8.20 8.47 Medium term 0.95 7.20 8.39 Long term 2.75 6.70 9.67 Average

  • 8.84
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Cost of Capital: January 2008-present

DCF, CAPM, and DCF-CAPM average

– Following interest rates, COK has decreased since mid-2008 – Presently, COK approximately 9.5%

March 20, 2012

8 9 10 11 12 13 14 DCF CAPM DCF-CAPM Average

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Cost of Capital: January 2008-present

DCF components for property-casualty stocks – Dividend yields: approx 2% – Expected growth rates: between 9% and 11.5% – Higher COK for prop-casualty stocks usually due to higher expected growth in dividends (without changing yields because stock prices are bid up)

March 20, 2012

2 4 6 8 10 12 14 16 Div Yld Growth Rate

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Cost of Capital: January 2008-present

CAPM: beta coefficients for property-casualty stocks

– Stable between 1.05 and 1.15 – Most of changes in estimated CAPM are due to changes in interest rates

March 20, 2012

0.90 0.95 1.00 1.05 1.10 1.15 1.20 Prop-Cas Stock Beta

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Cost of Capital: January 2008-present

CAPM: key components are the equity-risk premium

– Chart presents short-horizon equity-risk premia: differences between annual return

  • n large cap stocks and short-term US Treasuries

March 20, 2012

  • 60%
  • 40%
  • 20%

0% 20% 40% 60% 1926 1928 1930 1932 1934 1936 1938 1940 1942 1944 1946 1948 1950 1952 1954 1956 1958 1960 1962 1964 1966 1968 1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010

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Cost of Capital: January 2008-present

CAPM: key components are the equity-risk premium

– Chart presents short-horizon equity-risk premia by decade

March 20, 2012

17.4 4.8 9.9 19.0 4.8 1.2 9.3 14.1

  • 1.6

14.9 2.1

  • 5.0

0.0 5.0 10.0 15.0 20.0 25.0 Equity-Risk Premium

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Cost of Capital: January 2008-present

CAPM: key components are the equity-risk premium

– Chart presents short-horizon equity-risk premia: differences between annual return

  • n large cap stocks and short-term US Treasuries

March 20, 2012

  • 50%
  • 40%
  • 30%
  • 20%
  • 10%

0% 10% 20% 30% 40%

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Cost of Capital: January 2008-present

CAPM: key components are the equity-risk premium

– Equity-risk premium is the difference between the annual return on large-cap stocks and a US Treasury – Alternative US Treasury “risk-free” securities;

  • Short: 1-month US Treasury bill
  • Intermediate: 5-year US Treasury bond
  • Long: 20-year US Treasury bond

– Chart presents short, intermediate-, and long-term horizon equity-risk premia by decade – Recent volatility has caused 80+-year risk premium to move more than usual

March 20, 2012

Horizon Risk Short Intermediate Long 1926-2007 8.5 7.5 7.1 1926-2008 7.9 6.9 6.5 1926-2009 8.1 7.2 6.7 1926-2010 8.2 7.2 6.7 1926-2011 8.1 7.1 6.6

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US Treasury Rates for Three-Month Periods

US Treasury rates for three months ending

– 1-month, 5-year, and 20-year returns

March 20, 2012

0.0 0.5 1.0 1.5 2.0 2.5 3.0 3.5 4.0 4.5 5.0 1-month 5-year 20-year

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Cost of Capital: Summary

March 20, 2012

8 9 10 11 12 13 14 15 16 17 1989 1992 1994 1996 1998 2000 2002 2004 2006 2008 DCF CAPM Reasonable RoR

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Cost of Capital: January 2008-present

DCF, CAPM, and DCF-CAPM average

– Following interest rates, COK has decreased since mid-2008 – Presently, COK approximately 9.5%

March 20, 2012

8 9 10 11 12 13 14

Jan-08 Apr-08 Jul-08 Oct-08 Jan-09 Apr-09 Jul-09 Oct-09 Jan-10 Apr-10 Jul-10 Oct-10 Jan-11 Apr-11

DCF CAPM Average

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Cost of Capital: Summary of Estimations and Findings

Two widely-used models: DCF and CAPM Cost of Capital estimated with widely used, publicly available data sources 23 years of Cost of Capital Most of estimated COK under DCF due to expected growth in dividends US Treasury yields have decreased over 1990-2011 period, with yield spreads following the economic cycle High correlation between Cost of Capital and US Treasury securities US Treasury securities and Cost of Capital lower since 2001, and then lower again since 2008

March 20, 2012