From a reader on last night’s piece:

David, can you expand on this – ” I would revise the concept of the cost of capital to make it credit-centric.  All the efforts to calculate the cost of equity capital from equity market correlations are bogus.  They don’t make any economic sense.  In most cases, the cost of equity should not exceed the yield on an average CCC bond.”

All valuation classes teach the equity market correlation method so it would be interesting to hear your views.

Equity exists in many forms.  In securitizations, equity is the tranche that takes the first loss and controls the deal.  In a mutual insurer/bank/thrift, etc.,  the book equity is held by the dividend-receiving policyholders.  The real equity is held by management, who actually control the place, because the dividend-receiving policyholders will not vote them out.  In a credit tenant lease, there is the guy that owns the property, and typically he puts up a teensy amount of equity, because there is a “credit tenant,” one that has an investment grade rating, and the mortgage is secured by:

  • the property
  • the senior unsecured credit of the “credit tenant,” whose lease payments pay the mortgage, and go directly to the lender, and
  • the equity owner.

In practice, the first two offer real security, and the third is a joke, sort of.  The thing is, if commercial property values inflate, there is a *lot* of leverage the the CTL structure for the owner of the equity.  And, if things go badly, most equity owners own the property though a thinly capitalized subsidiary.  Can’t squeeze blood from a stone.  “Heads, I win. Tails, you lose.”

Then there are more normal examples, like public and private equity.  The ownership is clear, though control varies considerably, considering the stakes that control investors have.

Contingent Claims Theory

Leaving aside options on equity, the equity of an investment is the most volatile investment that funds the assets of an economic entity.  The equity of an entity controls the entity, and possesses a valuable option — the option to abandon it all, and hand the company over to the next most junior investor.

Option valuation can tell us a lot about about the cost of capital.  The put option inherent in any debt can be measured, giving the following observations:

  • The more of the company that is financed with debt, the greater the risk of owning the equity (the default option is near the money), and the higher the cost of equity is.
  • The more volatile the economic results of the company, the higher the probability of bankruptcy, and the higher the cost of equity will be.
  • The underlying volatility of a company’s assets radiates out through it liabilities, with liability volatility increasing as liability claims become more junior.

In essence, thinking like a securitization, where you have many, many levels of debt, and as debt gets more junior, its yield rises as its economic prospects become more volatile.  Equity is not debt, but it is the juniormost claim on the assets and cash flow of the firm, even while it has control, which includes the option to adjust the capital structure.  (Had to add that, because it is important, but not strictly relevant to my argument.)

Holding the equity is holding control, with a complex option to adjust the capital structure, including the possibility of giving up control under bad conditions, or selling out under good conditions.  But now consider options on the equity — those options also imply a cost of equity capital:

  • The more volatile the at-the money option is, the higher the cost of equity.  (And the higher will be bond spreads…)
  • Another way to think about it is how expensive it is to set a floor under and equity investment.  Volatile companies have higher insurance premiums for their stocks.  That implies a higher cost of capital.
  • Using options, we can create pseudo-bonds, where we can lock in a certain range of returns.
  • A capital structure hedge fund can trade corporate debt and CDS [Credit Default Swaps] against equity options — they all price off of the volatility of corporate assets in the short run.
  • For any capital structure, the return on the assets can be modeled over a variety of credit scenarios.  Those returns can translate into returns for the various liability classes — e.g. trade claims, bank debt, senior unsecured debt, junior bonds, preferred stock, equity, and given the current prices for each class, the yields and yield spreads can be calculated, as well as the probability and severity of loss.


Cost of equity is a function of the overall volatility of the value of corporate assets, and the degree of leverage the firm employs.  This is how the cost of equity should be calculated.  Using a method like this, I believe the estimated cost of equity would be lower than what MPT models would produce, and the equity would display significant optionality, having very low returns under stress and very high returns under the best scenarios.

If we calculate the cost of equity like this, it will be an enhancement to DCF, and not require the bogus assumptions of MPT, because:

  • Risk is risk of monetary loss, not correlation to an index
  • Beta is not a stable parameter; correlation coefficients are not stable either.
  • This fits with the way that actuaries would price complex credit insurance policies, if they thought hard enough about it.
  • This fits with contingent claims theory, which legally describes the claim structures for competing classes of liabilities.

This is my theory of asset/liability/equity pricing in broad. Comments are welcomed.

Most of Friday I spent as judge at the Global Investment Research Challenge for Washington, DC and Baltimore.  I really like working with students.  They are so earnest, and they work so hard.

Last year, the company was Under Armour, which was tough because it was a growth company.  Very difficult to value.  This year, the company was Marriott, which I think is even harder to value because of its asset-light strategy.   Further, they have bought back so much stock that not only is the company’s tangible book value negative, but the unadjusted book value is negative too.

But for what it is worth, the students this year had similar views about the target company, and the range of target prices was small versus what I saw with Under Armour.

But when I listen to the students, I sometimes cringe, because I’ve studied statistics to a far higher degree.  Now, when I judge, I don’t take my views into account, because I know I am in the minority, and the students don’t know that they are getting bad methods for analysis.  Let them listen to their professors, who don’t have a clue as to how the economy really works, and express what they have learned.

But if I had control over what Finance students were taught, I would do the following:

1) I would reduce the math content for finance students and increase the qualitative understanding of markets.  No more MPT.

2) I would increase the level of understanding on how to relate with people, because that makes a big difference in negotiating trades.

3) I would want them to work in a simple business, like a hot-dog cart, or mowing lawns, so that they could begin to get an idea of how tough it is to earn a profit.  My best boss in my life grew up watching his parents’ delicatessen, and it shaped his view of how to make a profit.  I didn’t have that as a kid, but I did have two parents who pointed out to me that life wasn’t easy.  The profits of my Dad’s business were by no means certain, and evaporated in the early 80s.  My Mom reinvested much of my Dad’s earnings into her stock portfolio, far exceeding what most investors achieve, but with periods that would make you wonder.  I partly paid for some of my college education by encouraging my Mom to buy a company that she previously sold that several years later went private for a handsome price.

4) I would revise the concept of the cost of capital to make it credit-centric.  All the efforts to calculate the cost of equity capital from equity market correlations are bogus.  They don’t make any economic sense.  In most cases, the cost of equity should not exceed the yield on an average CCC bond.

5)  I would tell them that changes in inflation and real GDP don’t have as large of an impact on corporate profits as is commonly thought, both positively and negatively.  I would tell them to focus on the stock, and drop the complex model.  Few in the investment business work off a complex model, and if you need one, you can buy Value Line, which I like, which tries to use a single macroeconomic model for 1700 popular stocks.  (and I get the model for FREE, because my county library subscribes to the WHOLE ENCHILADA, and I can ride on their back.  Morningstar too.)  I’m generous with my insights, but I rarely pay for services, because I know that they can be obtained cheaply, most of the time.


I would teach students to think on a higher level.  Not this causes that, but this influences that, and a lot of other effects occur as a result.  This is similar to Howard Marks’ concept of “second level thinking.”

By the way, I would do the same thing for the SOA and CFA syllabuses.  Modern Portfolio Theory is garbage, and needs to be abandoned.  We understood the markets better prior to MPT,

I would teach students that markets are not neutral, and that there are people out there trying to deceive you.  I’ve had more than my share of charlatans that I have had to oppose.

In place of randomness, and statistics that imply randomness, I would teach about margin of safety, and tell them, “Do your hard work.  Analyze likely profitability.  Analyze free cash flow.  Analyze the likelihood that you are correct; make sure the price at which you are buying includes a significant margin of safety.”

I would tell them to analyze free cash flow.  Today, with the company Marriott, that was the only thing that mattered.  One team hit the nail on the head. The rest did not.  The team that hit the nail on the head is going to Toronto to compete in the North American competition.  Should they win, they go to the final round, I know not where.


Anyway, that is a start.  As with Buffett, who always thinks of what is the best way to earn and compound earnings, it is far better to analyze successful businesses than to analyze what academics think about business.  After all, what, academic has created a successful business?  Few, if any.



  • Cargill joins Wall Street banks as swap dealer Could b a good idea 4 any firm that does much commodities hedging $$ Feb 22, 2013
  • Office Depot To Buy OfficeMax? And Then There Were Two. 0 + 0 = -1 Combined company faces $AMZN undercutting them $$ Feb 21, 2013
  • U.S. Insurers Resist Push to Make Gun Owners Get Coverage It hasn’t worked that way with cars; this is a good idea $$ Feb 21, 2013
  • $OMX & $ODP merge — market doesn’t like it, combined companies worth less than before the merger rumor emerged $$ Feb 20, 2013
  • Buffett brand has more beans than Heinz The investor has won every advantage in the deal, writes Alice Schroeder $$ Feb 19, 2013
  • Bondholders Dislike Uncertainty in Berkshire-Heinz Deal Bondholders, Buffett *never* assumes acquired debt $$ #patsies Feb 19, 2013
  • Annaly Reversing Slump as Denahan Tries to Dodge Fed $NLY changes its character as Fed crowds them out of RMBS $$ Feb 19, 2013
  • The Pitfalls of Dividend Yield in the Oil Patch The higher the dividend yield the less $$ 2 pour in2 exploration/growth Feb 19, 2013
  • Reader’s Digest Is Bankrupt; Iconic Magazine Falters 2 much debt & competition from internet; private equity failure $$ Feb 18, 2013
  • Danone Stake Poses a Challenge for Heinz Investor Peltz Much harder 2 get changes in France than the US. Won’t work $$ Feb 18, 2013
  • US Airways Wins AMR as Horton Said to Wage Last CEO Push CEO job went 2 visionary who saw a way 2 create value $$ Feb 17, 2013
  • Amazon Sells Out Predator Drone Toy After Mocking Reviews Don’t like it keep quiet; mocking draws more attn & sales $$ Feb 17, 2013
  • What? Carl Icahn Just Thinks Selling Diet Shakes And Herbal Tea Is A Really Good Business nuances of synthetic long $$ Feb 16, 2013
  • McGraw-Hill Credit Rating Cut by Moody’s After U.S. Sues S&P Less 2 this than some say; it’s just business, baby $$ Feb 16, 2013


Rest of the World


  • Waiting for a Crisis Wishful thinking on this side of the Pacific, but China needs to reduce the size of government $$ Feb 20, 2013
  • Cyberwar With China Is Here, Like It or Not Most systems can be compromised from inside by inviting someone 2 err $$ Feb 19, 2013
  • Spanish Debt Grows by Euro146 Billion, Largest Ever Recorded; Debt-to-GDP Highest Since 1910 Spain will leave EZone $$ Feb 19, 2013
  • G20 currency truce shortlived as Japan mulls foreign bond buys Japan decided G20 meeting gave a free pass to devalue $$ Feb 19, 2013
  • China’s New Leader Needs Grip on Wacko Next Door Instead, trade Taiwan for North Korea. Interests become aligned $$ Feb 19, 2013
  • Saxo Bank CEO Says Euro Is Doomed as Currency Woes Resurface CEO: “Right now we’re in one of those fake solutions” $$ Feb 18, 2013
  • Billionaire Miner Fights Rivals to Halt Digs on His Ranch Interesting Aussie mining claims law; u only own top meter $$ Feb 18, 2013
  • Mrs. Watanabe Dumping Australia Debt Signals Turn for Yen JPY Retail FX speculators try to pick a top for the AUD $$ Feb 18, 2013
  • How China’s President Is Earning A Nobel Peace Prize If true, many unlawfully detained in China may be freed $$ Feb 18, 2013
  • Ugliest Danish Banks Find No Buyers in Toxic Asset Trap 2 much leverage in system makes resolutions hard. Who can buy? Feb 18, 2013
  • BlackRock Sounds Covered Bond Collateral Alarm Weaker collateral & larger haircut did not work well 4 securitization $$ Feb 18, 2013
  • CDS Uncertainty Adds to Fear on Europe Bank Bonds Y don’t the protection buyers get paid by sellers? No auction poss $$ Feb 18, 2013
  • Hugo Chávez Returns to Venezuela I wouldn’t get 2 excited; rare that he would fully recover after so many operations $$ Feb 18, 2013
  • Japan flirts with equity targets to drive a stake in the zombie economy Targeting yields& equity prices doesn’t work $$ Feb 18, 2013
  • EU Economy and Horse Meat Scandal: Both Finishing last at the Gate – Germany to follow? EZone Core falters, what2do? $$ Feb 18, 2013
  • Celebrating the end of the eurozone affair ignores the heart of the matter Problems reappear after victory declared $$ Feb 18, 2013
  • Group of 20 chiefs take stand on exchange-rate policies Basically, nothing happened, everyone hopes it goes away $$ Feb 18, 2013
  • Hollande Tiptoes Toward Raid on Pensions With EU Pressure No way to make the budget balance; needs many, too little $$ Feb 17, 2013
  • Walking-Pace Trains Spur $17 Billion India Rail Revamp I don’t believe in the BRIC nations; all have huge problems $$ Feb 16, 2013
  • Auto Keiretsu Wracked by Antitrust Probes Friendly collusion 4 the purpose of quality, or profit? Not allowed in US $$ Feb 16, 2013




  • Cardinal Dolan Preps for Conclave Vote on New Pope “Bring Peanut Butter” & other tips for traveling Cardinals. 😉 $$ Feb 21, 2013
  • Sewage Status Grows as Resource for Utilities to Skiers Amazing what we can do2 convert waste to power $$ Feb 21, 2013
  • Gasoline Pump Prices Soaring on Refinery Repairs, Oil Rally Rising crude prices & refinery outages raise gas prices $$ Feb 20, 2013
  • Ironing Out the Wrinkles—The Complexities of Madeleine L’Engle As a kid, I loved ML, opinion has always fallen since $$ Feb 19, 2013
  • Rotten Egg Gas Seen Offering Promise of Extending Life Hydrogen Sulfide – up to a limit we could all use more of it $$ Feb 19, 2013
  • What Doesn’t Kill Us Makes Us Stronger Small problems lead to product & service improvement & more robustness $$ Feb 18, 2013
  • Close Encounter by Asteroids Makes Case for Scrutiny We humans always fight the last war; remember the avian flu? $$ Feb 16, 2013


Credit Conditions


  • Junk Bond Froth Seeps into Emerging Markets I prefer emerging market gov’ts to corporate junk, they are run better $$ Feb 20, 2013
  • Bubbles and fraud: A smoking gun? Easy profits always brings out the worst in people; no wonder fraud increases then $$ Feb 20, 2013
  • The Indianapolis 500 of Corporate Bonds Yields The trend chaser are blowing out of credit; avoid 4 now, b cautious $$ Feb 19, 2013
  • Finra bond warning a real worrier Dog bites man. Many have predicted long rates would rise & they haven’t (so far) $$ Feb 18, 2013
  • Debt Bubble Born of Easy Cash Prompts Swedish Rule Review $$ policy should not be used 2 stimulate; 2 much debt kills Feb 18, 2013
  • Super-prime’s invisible driver Would u rather hold govt bonds or prime property? Which will lose less? @izakaminska $$ Feb 18, 2013


US Politics


  • Obama’s Deficit Commission Leaders Offer New Debt Plan 50% cuts, 25% adjustments 2 Medicare, 25% close tax loopholes $$ Feb 19, 2013
  • How to Fix Too Big to Fail Without Taxpayer Bailouts: Rep. Campbell’s Plan Plan is reasonable; receivership4BK banks $$ Feb 19, 2013
  • Pentagon Budget Stuck in Last Century as Warfare Changes More smaller weapons, lower tech, fewer ppl, more skill&mobile Feb 19, 2013
  • All-the-Right-Skills Immigrants Ride US Hiring Wave: Economy Note many in US have those skills & get screened out $$ Feb 19, 2013
  • Obama Golf With Woods in Florida Risks Muddling Message Give Obama a break; he deserves a little fun too $$ Feb 19, 2013
  • Fiscal trouble ahead for most future retirees I predicted 20 yrs ago: Many Baby Boomers won’t b able 2 retire $$ Feb 18, 2013


Market Impact


  • Paulson Leads Funds to Bermuda Tax Dodge Aiding Billionaires After all that Paulson lost $$ rendering no tax savings Feb 19, 2013
  • Performance Tops Pedigree in Money Managers’ Fortunes Story of two $$ mgrs & how performance drove their stock prices. Feb 17, 2013
  • Upside: Why Most Value Investors Will Burn Out You have to be willing to look like an idiot & be patient 2b rewarded $$ Feb 16, 2013
  • Confidence on Upswing, Mergers Make Comeback 2 early 2 say. Profit margins r2 high & interest rates 2 low; unstable $$ Feb 16, 2013


  • Wrong: Let’s Downgrade S&P, Moody’s Ratings Oligopoly Writer does not understand the needs of regulators or bond buyers Feb 19, 2013
  • Wrong: Swelling US Labor Force Keeps Fed at Ease Every statistic I c on labor force participation says otherwise $$ Feb 19, 2013


Replies & Retweets

  • @TheStalwart Hey Joseph, thou hardest working guy on Wall Street, Congrats on your promotion at BI — it is well-deserved Feb 21, 2013
  • If I were long $HNZ now, I would sell; likely there is no better deal coming along, & upside is only 0.5% $$ Feb 20, 2013
  • “Johnson will report to 3G; they have all of the incentives to cut costs and recognize synergies…” — David_Merkel $$ Feb 19, 2013
  • SEC EDGAR seems to be down, at least the search function isn’t working… Feb 19, 2013
  • @TheStalwart pick a medium-nice suburb of Rome. I grew up in the county of Waukesha, WI, FWIW. Feb 19, 2013
  • “These aren’t bargains; buying them @ these prices assumes they grow rapidly for the next 5 years.” — David_Merkel $$ Feb 19, 2013
  • ‘ @groditi Yes, reviewing it tonight. Agree about conviction; book’s only drawback is that if you get his emails, not much new $$ Feb 19, 2013
  • “When I analyze mutual funds, I look at active share and process — are they doing it right? Do…” — David_Merkel $$ Feb 19, 2013
  • Illegal, you used “US postal service” & “innovate” in the same sentence $$ RT @ReformedBroker: CAN THE US POSTAL SERVICE STILL INNOVATE? Feb 18, 2013




  • My week on twitter: 34 retweets received, 3 new listings, 49 new followers, 39 mentions. Via: Feb 21, 2013