Comparison of the Capm Dcf and Bond YieldplusRisk Premium Methods

We have discussed three methods for estimating the required return on common stock. For NCC, the CAPM estimate is 14.6 percent, the DCF constant growth estimate is 14.5 percent, and the bond-yield-plus-risk-premium is 14.4 percent. The

10See Robert Harris, "Using Analysts' Growth Rate Forecasts to Estimate Shareholder Required Rates of Return," Financial Management, Spring 1986, 58-67. Analysts' forecasts are the best predictors of actual future growth, and also the growth rate investors say they use in valuing stocks.

overall average of these three methods is (14.6% + 14.5% + 14.4%)/3 = 14.5%. These results are unusually consistent, so it would make little difference which one we used. However, if the methods produced widely varied estimates, then a financial analyst would have to use his or her judgment as to the relative merits of each estimate and then choose the estimate that seemed most reasonable under the circumstances.

Recent surveys found that the CAPM approach is by far the most widely used method. Although most firms use more than one method, almost 74 percent of respondents in one survey, and 85 percent in the other, used the CAPM.11 This is in sharp contrast to a 1982 survey, which found that only 30 percent of respondents used the CAPM.12 Approximately 16 percent now use the DCF approach, down from 31 percent in 1982. The bond-yield-plus-risk-premium is used primarily by companies that are not publicly traded.

People experienced in estimating the cost of equity recognize that both careful analysis and sound judgment are required. It would be nice to pretend that judgment is unnecessary and to specify an easy, precise way of determining the exact cost of equity capital. Unfortunately, this is not possible—finance is in large part a matter of judgment, and we simply must face that fact.

Which approach is used most often by businesses today?

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