High inflation and rising (though historically low) interest rates are making it more difficult for executives to estimate the cost of equity as part of their financial planning. In part, that’s because many are heavily weighting the arguments from some academics and bankers that rising interest rates have increased the cost of equity and have been a factor in lower equity valuations since the beginning of 2022.
The academics and bankers have likely come to these conclusions because they are using the textbook approach to estimating cost of equity—namely, using government bond yields as a proxy for the risk-free rate typically plugged into capital asset pricing models (CAPM) and adding a historical market risk premium of 5 percent.
This textbook approach would suggest that lower interest rates during the COVID-19 pandemic resulted in higher total shareholder returns (TSR) in 2020 and 2021, while higher interest rates in early 2022 then proceeded to drive down TSR. Under this approach, the current cost of equity would be about 8 percent (a 3 percent risk-free rate plus a 5 percent market risk premium) versus 6.6 percent (a 1.6 percent risk-free rate plus a 5 percent market risk premium) at the start of 2022.
But are government bonds really the best proxy for the risk-free rate?
If executives adopted a different approach, using an artificial risk-free rate in CAPM estimates, they would recognize that the cost of equity has increased only slightly, and valuation multiples for companies have not meaningfully changed when compared with historical numbers. (The latter may be especially relevant for executives who are valuing corporations or investment decisions with long-term cash flows.1) Our own calculations show that in the past 60 years, the real cost of equity has remained stable in the 6.5 to 7 percent range, while only the nominal return has changed meaningfully over time.
In a 2018 analysis, for instance, we used 9 percent as the estimated nominal cost of equity for the typical large US company, reflecting an artificial risk-free rate of 4 percent with a market-risk premium of 5 percent. When we subtracted the then-expected inflation rate—1.7 to 2.3 percent, or an average of 2 percent—the real return on equity was around 7 percent. That was consistent with the observed real expected returns for the S&P 500 from 1962 to 2018. Even factoring in recent higher inflation levels (or 2.4 percent expected inflation), the current cost of equity is about 9.4 percent (the 7 percent real return plus the expected inflation).
Of course, once interest rates rise above long-run averages, business leaders should take the time to reevaluate their perspectives. But in this inflationary environment, using an artificial risk-free rate in CAPM models can ease some of the challenges of estimating cost of equity.
1. This analysis was undertaken before the COVID-19 pandemic, but the approach discussed may be especially relevant now, given ongoing market uncertainties.
Vartika Gupta is a solution manager in McKinsey’s New York office, where David Kohn is a senior knowledge expert and associate partner. Tim Koller is a partner in the Denver office. Werner Rehm is a partner in the New Jersey office.
For a full discussion of this topic, see Tim Koller, Marc Goedhart, and David Wessels, Valuation: Measuring and Managing the Value of Companies, seventh edition, Hoboken, NJ, Wiley Finance, 2020.