Cost of Equity estimates in Brunei

// April 12th, 2009 // Business

How does one estimate a Cost of Equity (Ke) for a business in Brunei?

Here’s a rough-and-ready way to estimate a Cost of Equity, using the timeless Capital Asset Pricing Model:

CAPM gives us rj = rf + β (rm – rf)

Where:
rj = An estimate of the expected return of an investment
rf = the Risk-free rate
β = a statistical measure of the degree of systematic risk of a security (i.e. the sensitivity of an investment to movements in the general market. high Beta = high risk (high fluctuations), low Beta = low risk (low variability in return))
rm = the expected return on the “market portfolio”.

So lets plug through this calculation.

Risk Free Rate

Where are you going to get a risk free rate from? Well you could use 0.5%, which is equivalent to the 1-year return on Brunei Government sukuk bonds. FYI – a Sukuk is a syariah-compliant debt instrument securitised on a basket of cash-generating assets. The irony that I’m using a syariah-compliant financial instrument (some scholars would argue that these aren’t supposed to be paying interest or “Riba”) to estimate a risk-free rate is not entirely lost on me.

Or maybe it’s better to take a more rate like 3% – the return on TAIB 1 year deposit certificates. Either way – 0.5% or 3% the calculation below still returns an answer that is more or less the same.

β (Beta) and rm

One way for SME’s to estimate β and rm is to look at a basket portfolio of securities of companies operating in similar markets. I like to use the Fortune 500 list.

So, say you want to estimate Ke for the Hotel, Casinos and Resorts industry: From this group of Fortune 500 companies, lets take NYSE:MAR, NYSE:HOT, and use these 2x selected companies as our basket for comparison. You may want to use other companies for your comparison, or use alternate data sources. A good idea would be to use Singapore/Malaysia stock exchanges instead.

From this published financial information, you can take an average of the two key ratios you need: Beta and the “Dividend Yield” ratio. You may want to use a weighted average, and give a higher weighting to companies that more accurately fit the kind of company you’re calculating ke for.

For those who are really paying attention, we’re using Dividend Yield as a shortcut. Actually, you would get better results if you take rm = D1 / P0. i.e. an estimate of next year’s (D1) dividend per share divided by the current share price. Because using just the “Dividend Yield” shortcut =  D0 / P0. So I guess you could say that we’re being prudent and not taking into account 1 year’s dividend growth estimate. Conversely, in this economic climate, you might say we’re being over-optimistic and not taking into account the possibility of the business shrinking in the future period! Well, better to be approximately right than accurately wrong, I say. Use the future estimates if you have, if not, just make do with what you got!

After you have an average β and rm from a portfolio of similar securities, I always like to inflate rm by a rule-of-thumb 300 basis points (or around +30%, whichever “feels” right). This tries to take into account the risk profile of doing business in Brunei, and invariably you’re trying to estimate ke for a Bruneian SME, which will mean private equity. A lack of pre-existing secondary market, difficulty to trade in the instruments and overall lower requirements of disclosure & corporate governance all factor in. Actually, why don’t you hike it up a further 500 basis points, just to be safe :-?

Now you just plug everything back into the CAPM formulae, and you should get an answer. Based on my spreadsheet, I got a β of 1.39 and an average dividend yield of 4%. Add on say 300 basis points, rm = 7%. Plugging it into CAPM I get rj = 9%.

You can now use that estimate of rj in your capital appraisal techniques 8-)
Personally, I’d set an enterprise-wide hurdle rate of say 12% … the extra 3% is your “psychological” carrot/stick to encourage staff to take maximisation of shareholder wealth seriously.

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