RISK
AND OPPORTUNITY
COST OF
CAPITAL
Asset Pricing
Asset pricing and valuation in markets can be stated broadly
as what a buyer willing to buy, and a seller willing to sell, would agree to be an assets fair value.
With income producing assets, however, there have been developed a series of formulas which are universally
recognized and applied to such assets as stocks and bonds, real estate, and businesses of every kind.
Each of these diverse valuation formulas have universal components
which underlie the value of everything that has income producing potential. The chief component is the
cash flows to be received by the investor over a specific time frame, called the "holding period". Since
all assets are purchased with after-tax dollars, all cash flows to be evaluated have to be reduced to
cash-flows-after-tax., which involves gross cash flow estimations and the development of accounting net
profit by subtracting manufacturing, operating and financial expenses, including taxes, and then adding
back to the net profit those non cash charges, such as depreciation, to develop the net after tax cash
flow.
Once estimated cash flows have been developed, the risk-return
percentage for the receipt of those cash flows has to be calculated. In other words, in order to place
a value on the receipt of those flows, the buyer need a sense of the percentage of return to which he
is entitled to be appropriately compensated for the risk undertaken in purchasing them. This sense of
the required rate of return can be most readily determined in the market, where the buyer of such cash
flows can determine what others, who have recently purchased cash flows from similar business, were willing
to pay for those cash flows. In other words, the sense of this percentage is cash flows/price.
For example, if the cash flows were $100,000 per year and the price paid for them was $1,000,000, that
means that a recent buyer required a 10% annual return on the investment purchased. If a buyer of cash
flows does not have recent market transactions to refer to, then its important to have an analogous product
or company to reference.
In the prior example, we assumed that the cash flows of $100,000
would not change. The third element in the valuation of any asset is the projected growth of the cash
flows. This idea was captured by a financial thinker named Gordon who devised a formula which recognizes
the three elements of asset value: cash flow, risk, and cash flow growth. The Gordon formula, otherwise
known as the Constant Growth Dividend Valuation Model, is that the value or price of any asset is:
V = C/(R-G).
In our prior example, if the cash flow was $100,000, the
risk was 10% and the growth of those cash flows was assumed to be 5%, then the value of the asset would
be:
$100,000/(.10-.05) = $2,000,000.
Or to put it another way, if the buyer paid $2,000,000 for
that asset and did realize an annual return of $100,000, growing at 5%, the buyers return would be:
R=C/P +G = $100,000/$2,000,000 + .05= .10
