Cost of Equity Facebook

¶ … equity at Facebook is to use the capital asset pricing model. The formula for CAPM is as follow:

Rj = RF + ?j [RM - RF]

The first step to determining the cost of equity is to gather the different variables go into CAPM. The risk free rate is the first such variable. The risk free rate reflects the rate of return that an investor can earn on an investment that has no risk The only investments that are deemed to have no risk are Treasury securities. This is because the U.S. Treasury prints money, so there is zero risk that these will not be repaid. There is risk that the payment will not have the same real value, but it will have the same nominal value as expected.

According to the U.S. Treasury webpage, a one-year Treasury bond carries with it a rate of 0.13%. This is the risk free rate to be used in the capital asset pricing model calculation.

The next step is to calculate the market risk premium. This is assumed to be 5%. This means that the component of CAPM that is [RM - RF] is 5%. The expression RM must be 6%, given this.

The remaining variable is the beta, which is the expression of the correlation between the performance of the company and performance of the general market. The beta essentially is the firm-specific risk of the company while the other components of CAPM are the risk-free rate and the market risk premium. Facebook began trading in May, 2012. There is a beta listed on Yahoo Finance of 1.77 for Facebook, so this can be used to calculate the cost of equity for the company using CAPM.

R (fb) = 0.13 + (1.77)(5) = .13 + 8.85 = 8.98%

This figure is fairly high, but reflects two key facts about Facebook. The first is that the company has had a somewhat volatile history with its stock price thus far. The second is that the company's cash flows are still in a state of flux. Facebook's high profile contributes to this situation, and the company therefore has a high cost of equity.

The cost of equity is about what I might have expected. I expected a high level of volatility in Facebook's stock. There is one thing about comparing it to the S&P 500 return. The expected return on the S&P 500 is not 8.2% - this is not the average cost of capital. The average cost of capital for the market is as follows:

0.13 + 5 = 5.13%, because the beta on the S&P 500 is 1.0.

This is important, because it highlights a little more effectively how much riskier Facebook is that the market. The cost of equity for Facebook is not just a little bit more than the market; the cost of equity for Facebook is substantially higher than that of the market average. This is how it should be, as a young company that is trying to establish a business model in a challenging and competitive market environment.

Facebook is not the only company that is trying to excel in the online advertising business. Two others firms in this industry are Google and Yahoo. The beta for Google is 1.0, and the beta for Yahoo is 0.92. These companies are therefore both more stable than Facebook, which stands to reason because they have been around longer. Thus, they have more stable revenue streams owing to their stronger systems and customer relationships. The cost of equity for Google would be 5.13%, the same as the broad market, and the cost of equity for Yahoo would be 4.73%, slightly lower than the broad market risk.

Other Models

There are two other models that can be used to price out the cost of equity for these companies. The first is the dividend growth model and the second is the arbitrage pricing model. Using the dividend growth model is challenging because it relies on the company to pay a dividend. Right now, there is no dividend at Facebook. The model, in these situations, relies on the expectation of future dividend for its logic, but at this point there is no expectation of a future dividend so this model is challenged to be useful for a company like Facebook.

The arbitrage pricing model can be used. It has the same underlying logic as the capital asset pricing model. However, instead of using market returns as the critical variable, any number of different variables can be chosen. These variables are usually macroeconomic indicators that are linked to the business, such as GDP, unemployment, trade statistics and interest rates. Often, a basket of these variables is used, with weights assigned to reflect the importance of that variable.