http://www.bankofcanada.ca/wp-content/uploads/2010/06/zorn1.pdf
I never liked the theory of cost of equity in business school. It’s not really a cost per se for a company’s operations. It doesn’t (net) cost them a dime. The real cost to a company is that they might have to raise equity at less favorable prices, making it harder to meet their financing needs. But, if there is no additional share offerings coming from the company, then the cost of equity means nothing to them. (In the reverse case, when a company is doing share repurchases, it would prefer a higher cost of equity). Companies are motivated to raise equity when share prices are high, just when the prospective returns for shareholders are the lowest. Seems a little counter intuitive to think a lower cost of equity is a good thing (for shareholders) in this case. Of course if you previously held shares then you’d be delighted that you could sell for a good profit.
But to answer your question, I’m guessing the cost of equity is a bit higher in the Canada. Smaller market, less trading —> companies command lower share prices -----> Higher ‘cost of equity’, i.e., lower share prices.
i’m surprised they didn’t mention currency and analyst coverage effects. you can feel the effect of currency as it leads to greater stock volatility in Canadian stocks in general as currency hits revenues/earnings more so and also results in shifts in investment strategy for foreign investors. Canadians stocks have less analyst coverage in general and this results in less visibility in the global marketplace and thus less foreign interest in Canadians stocks relative to U.S. stocks. most global investors don’t want much currency exposure and since Canada is only ~4% of the global market cap, most global investors will opt for more familar and stable currencies like the USD, Yen and Euro and in doing so avoid Canadian stocks and securities in general. you will never be able to eliminate the higher cost of equity in Canada.
The cost of equity is simply the opposite side of the trade for “required return”. If an investor is going to provide equity, they expect a return from that in the form of income and capital appreciation over time.
For the company receiving capital, the cost of equity is simply what they will have to provide over time to keep investors from selling their stake at the first opportunity. They can provide it as dividends, or as retained income, or by a reality distortion field applied to their stock price, but they do need to provide it over the long run.
It’s true that if the company never needs to raise any more capital, and shareholders are complacent in their role as owners, the company never needs to pay a dividend or accumulate retained earnings, but there are precious few companies who have a goal of never growing and therefore never requiring capital infusions larger than their existing retained earnings. If shareholders are not complacent, then they wlll change management anyway in such a way as to provide tha return. And if any of the employees are paid in stock or options, they will definitely care about what happens to the stock price. If investors sell en masse because the company isn’t delivering the cost of capital, that sends the stock price down.
So the company doesn’t necessarily pay the cost of capital the way it makes interest payments (though it might, if it has a dividend policy). But at the same time, the cost of capital means it can’t invest in projects that don’t have a decent expected return that is higher than whatever WACC is.
So one way to get at the cost of equity in Canada is to look at what the required returns would be if you are an investor. So look at historical market returns in C$ and see what a local investor can get with a diversified portfolio, because unless you can get better risk-adjusted returns than that, why invest in a specific company. My guess is that the canadian market is a little less liquid and probably more than a little less diversified than the US market, which would suggest that it should be a little higher. If you are a US investor, you have to throw in some risk from currency, which would make the required return, but if you were a canadian investor in the US, you’d probably have the same currency concerns.
Interestingly, I’ve run the numbers off of Yahoo on TSX and SP500 returns from Dec 1979 to May 2016 and what I get is a return of 5.95% for TSX and 8.73% for SPX. These are most likely not total returns (SPX certainly is capital gains only). if the dividend yeilds are the same, this would suggest that Canada’s cost of capital is less than the US’s, when I would have expected it to be about the same. The gap is about 2.7% annually.
There are two things that might explain this. Firstly, the dividend rate might be higher in Canada (it seems like dividends are about the same, so it only accounts for a little bit). The other thing might be if Canada’s market is less risky, you should expect the cost of capital to be lower. It’s true that Canada did not have as large a crisis in 2008 as the US, but it was still highly exposed to the US through export relationships.
Finally, if you plot the difference in returns since the financial crisis, Canada did not see the same stock market boom after the crisis as the US. Indeed, TSX is only around its pre-crisis high, whereas the SPX is a good 30-35% higher. So if you think that the post 2008 period is a special period, you might just look at prices up to the crisis. – if you do that, TSX returns 7.55% annually, and SPX returns 9.06%. A difference of 1.5%.
I don’t have the time to look at the basic risk measures (SD and such), but I suspect that that the US market has greater volatility measures.
So it would seem that canadian equities do have a lower cost of capital than us equities, but the difference isn’t necessarily that large after accounting fror volatility risks.
^ the lower return can be explained by higher energy and materials exposure which underperformed over that time period which is also related to the low volatility anomaly. low volatility stocks have performed much better than high volatility stocks over a very long time frame. as canada has many more high volatility stocks and much fewer low volatility stocks, particularly if you compare the TSX Composite to the S&P 500, the TSX has underperformed due to this anomaly. comparing the TSX to the Russell 2000 might be a fairer comparison but there is no great US benchmark no matter how you slice it as the TSX has both megacaps and small/microcaps.
the only way to get a true comparison would be to compare our grocers versus your grocers or our insurance cos versus your insurance cos or something like that.
another factor for Canada’s great underperformance on a risk adjusted basis, is the Canadian curse in which all of our largest non-bank companies tend to die. Valeant, Nortel, Blackberry were all the highest weight on the TSX before collapsing to next to nothing. this adds to Canadian stock volatility versus the U.S. but likely doesn’t have much impact on long-term returns.
I agree that a better comparison would be to do an industry-by-industry comparison to control for the different asset exposures.
You’re right bchad. Management might not have to look at COE as a real cost in certain situations, but if they ignore the shareholders they could quickly find themselves out a job. In most cases upper management is compensated via options anyways, so they share the same interests. Regardless of the circumstance, COE should be factored into the Wacc as this is the only way the company will actually receive equity financing. No one’s gonna hand over money to invest in a project that only breaks even after operating expenses and interest payments. In school they said to valuate a company using a historical cost of equity approach. Personally though, I think I’d rather plug in my desired return into the equation and then wait and see if the market gives me that price someday.
Reality distortion field? Do you mean share repurchases?
I just mean that if the stock price is high due to marketing hype, many investors will accept that as a source of return, too, though the smart ones might decide to take the money and run before the hype wears off.