Question

How do I find out the cost of equity: beta analysis for Target Corporation (TGT)? Would I use CAPM? If so, how do I find the risk free rate, market rate of return and beta? Please help, I am very confused.

Answer 1

Following can be done to find Cost of Equity

Cost of equity = The equityholders' required rate of return is a cost from the company's perspective as shareholders are undertaking risk by investing into the company so the return which firm pays to the equityholders is the cost of equity only.  

It can be found out by two perspectives :- Dividend Capitalisation model or CAPM model

1) Dividend model:-

Cost of Equity= DPS​/ CMV + GR

where:DPS =dividends per share,

CMV =current market value

GR = growth rate of dividend

2) CAPM Model-

Cost of Equity = Risk-Free Rate of Return + Beta * (Market Rate of Return - Risk-Free Rate of Return)

Finding Risk-Free rate

Risk-free rate can be taken as yield on Treasury Bonds (depending upon the investment duration) as it is the most widely used alternative for calculating risk-free rate of return. The reason for using these treasury bonds as risk free rate is because these are backed by the U.S. Government. For example, say like 10-year Treasury bond yields 5%, so in such a case we will consider 5% to be the risk-free rate of return.

Finding Market rate of return

It can be found out by taking into account the historical returns of the similar assets in the market. Under this, in order to have better results, it is advisable to use long time horizons as it would help in giving better estimates. And further if we deduct the risk-free rate from the market returns, it will give us market premium, which is used in the formula of CAPM.

Finding Beta

Beta helps in giving the estimate of how volatile an asset or security is with respect to the market.

Beta can be calculated by using Variance/Covariance method:-

= Covariance of that asset/security and market / Variance of the market

For this data of the return of the market and the asset is to be taken on an excel sheet for a reasonable amount of time, say one year, then apply the function on excel of covariance by selecting the returns of both and then apply function on excel of variance by selecting the returns of market and finally divide both of then to find beta. For example, if beta is 2, it means that a particular security/asset is 200% times more volatile than market.