How does cost of capital affect stock valuations?

The economic damage brought about by the coronavirus pandemic last year has triggered a wave of companies seeking to raise capital to strengthen their balance sheets and prepare for acquisition opportunities.

Many companies are also taking advantage of the low interest rate environment by refinancing their long-term debts at lower cost as well as issuing new securities.

When a company raises capital from lenders and shareholders, both types of investors require a certain return on their investments. The lenders require the company to pay interest, while the shareholders expect the company to pay dividends.

The weighted average of this return, which combines the cost of debt and the cost of equity, is what we call in finance as the cost of capital.

Companies use this cost of capital as its hurdle rate in evaluating projects, as well as valuing investments.

Similar to cost of equity, a lower cost of capital increases the present value of a company’s future cash flows, which can result to higher stock prices.

For example, in 2019, when the 10-year government bond yield fell to 4.75 percent from 6.4 percent in 2018, the weighted average cost of capital (WACC) of JG Summit, based on market values, also fell to 9.4 percent from 11.1 percent.

The lower cost of capital, which implied undervaluation, resulted in higher stock price for JG Summit, which increased by 45 percent by the end of 2019.

We derived the cost of capital of the stock by taking the weighted average of its cost of debt and cost of capital based on market value, not book value, to reflect the true strength of the company.

Now, the cost of debt, which is computed by taking the prevailing 10-year government bond yield plus default spread, can also increase significantly if a company’s operating income falls against its interest expenses.

When a company struggles to generate enough earnings to cover its interest expense, a decline in interest cover ratio means higher risk of default.

This increase in risks leads to higher default spread, which increases the cost of debt of a company.

So, in 2020, during the coronavirus pandemic, where majority of companies suffered losses, the weighted average cost of capital of JG Summit, based on market rates, increased to 10.1 percent, despite continued decline in 10-year bond yield to 2.99 percent.

The increase in cost of capital limited the stock’s recovery to end the year with a slight loss of 7 percent.

The trend in cost of capital also mirrored the movement in the Philippine Stock Exchange Index (PSEi) in the past.

Historically, the average WACC of stocks belonging to the PSE Index is indirectly correlated with the market in 18 percent of the time.

When the average WACC of the market declined to 7.27 percent in 2019 from 8.91 percent in 2018, the PSE Index managed to increase by 4.7 percent.

But in 2020, when the PSE Index lost as much as 48 percent during the height of the crisis, the continued fall in average WACC to 6.76 percent enabled the market to recover with loss of only 8.6 percent by year-end.

Today, the average WACC of the market has slightly increased to 6.84 percent and the PSE Index is so far down by 2 percent from last year.

As interest rates are expected to remain low this year despite the rise in inflation recently, the low average WACC in the market should attract more investments, which should help sustain the PSE index’s recovery.

However, we should remember that the WACC, being a risk indicator, is just one part of the equation. The other part that we need to consider is growth.

New investments brought about by low interest rates must generate growth in revenues and future cash flows to justify a higher market valuation.

Otherwise, if the economy fails to respond positively, slower consumer spending growth will mean lower sales and earnings, which could lead to higher WACC and eventually lower stock prices. INQ