Estimating Cost of Capital for Ameritrade: CAPM Analysis

Introduction: Ameritrade's Strategic Investment Decision

Ameritrade faces a significant strategic decision: whether to invest $100 million in new technology and support that investment with an advertising program costing $155 million over the first two years. At the heart of this decision is the question of return on investment — and how to estimate the appropriate cost of capital for a project of this scope and novelty.

Ameritrade has identified a strategy that allows it to differentiate itself from competitors by becoming a low-cost provider that makes money on volume. CEO Joe Ricketts articulated the goal of becoming "the largest brokerage firm worldwide based on the number of trades." The critical question is whether this niche is large enough to support such ambitions, and whether the proposed investment will deliver the necessary returns.

Key Factors to Evaluate Before Investing

Ameritrade's target market has specific needs, and the firm must understand them precisely. It believes price and transaction speed are the primary drivers. However, Ameritrade must also assess the degree of demand elasticity for each of these features — and whether this investment will actually deliver improvements on both dimensions.

Another critical consideration is the source of additional customers. Significantly increasing trade volume will require either attracting new investors to the market or capturing market share from existing brokerages. If Ameritrade is poaching customers from competitors, those competitors will respond. This raises an important question about the sustainability of any competitive advantage gained: if Ameritrade's rivals match its technology investments, the advantage could prove temporary.

The target investor attracted by low prices and fast execution is unlikely to be brand loyal. They are loyal to price and speed. If competitors respond by matching Ameritrade's capabilities, the market share gains could be reversed. That said, such technological change may be inevitable regardless, meaning any advantage — temporary or not — is worth seizing.

A further key issue is how to classify the nature of this investment's risk. There is genuine disagreement about whether this investment should be evaluated as pertaining to a brokerage firm or to an Internet firm. This classification matters because it directly affects the estimated risk level and, therefore, the appropriate discount rate. Ameritrade has historically been a technological leader in the discount brokerage industry, but the Internet had come to be regarded as a business category unto itself.

The Capital Asset Pricing Model (CAPM) can be used to estimate the cost of capital for this investment. CAPM estimates the risk of an asset by evaluating it relative to overall market risk. Each asset has its own specific risk factors, which should be assessed independently of the firm's overall risk profile.

In Ameritrade's case, this distinction is especially important. The company is making a fundamental change to its business model. The risk level of its previous investments is not necessarily indicative of the risk level of this particular investment. CAPM accounts for this by setting a discount rate appropriate to the risk of the future investment rather than relying on a rate derived from past activity.

Applying the Capital Asset Pricing Model

CAPM states that the expected return on an asset equals the risk-free rate of return plus the market risk premium multiplied by the asset's beta:

Expected Return = Risk-Free Rate + Beta × Market Risk Premium

The risk-free rate is generally taken as the prevailing yield on government securities. For this investment, the time horizon matters. Because the investment is long-term in nature, the appropriate comparison is a risk-free instrument with a similar timeline. The relevant comparison is to current market rates, since both options — investing in the project or in government securities — represent choices to be made today.

Determining the Risk-Free Rate and Market Risk Premium

The two most relevant maturities are the five-year bond (6.22%) and the ten-year bond (6.34%). Since the rates are similar, the shorter time frame is more appropriate. Although Ameritrade is spending this money to pursue a long-term strategy, the online brokerage environment is changing so rapidly that the new technology is likely to be obsolete within five years.

There are two views on which market risk premium and beta should be applied. A direct competitor, eTrade, positioned itself as an Internet business; an ABN-Amro analyst echoed this view, grouping Ameritrade with firms such as Yahoo and Netscape. The alternative view holds that Ameritrade is primarily a brokerage firm. Ameritrade's growth is tied to stock market trading volumes, not to the growth of the Internet as a medium. This distinguishes it from purely Internet businesses whose expansion tracks the growth of the web itself.

That said, the Internet is changing how companies conduct business across many industries. If the discount brokerage industry grows because of the Internet, and Ameritrade leads that transformation, it would be inappropriate to value Ameritrade solely alongside non-Internet companies. This investment fundamentally changes the nature of discount brokerage, meaning that firms in the sector should carry some Internet component in their valuation going forward, given their increasing dependence on the web for revenues.

Given Ameritrade's size, the appropriate market risk premium is that for small companies: 17.7%.

Selecting Comparable Firms and Estimating Beta

There are two approaches to estimating asset beta. Ameritrade's own stock market beta is not a reliable measure, given that the company had only been publicly traded for a few months. A more useful approach is to use the betas of comparable firms.

eTrade is the most defensible comparable. It is a close competitor in the discount brokerage space that is also using technological innovation as a source of competitive advantage. Since Ameritrade went public, its stock has traded in a pattern similar to eTrade's — the notable exception being July, when eTrade posted a large gain while Ameritrade remained flat. The overall similarity between the two firms suggests they will track the market in a comparable fashion over time. Other firms, such as Charles Schwab and Quick & Reilly, operate in the same general industry but do not track as closely.

Pure Internet and technology companies are not appropriate comparables because Ameritrade does not develop technology, and its business depends primarily on stock market trading volumes rather than on Internet adoption rates. Full-service brokers also make poor comparables, as they have different revenue streams and ancillary businesses that reduce their relevance. Waterhouse's comparability is further undermined by the fact that it is no longer publicly traded; beta data from the telephone era of discount brokerage has limited value when evaluating a decision about entering the Internet era.

This leaves eTrade as the only logical comparable for estimating asset beta. Waterhouse, while also a discount brokerage, suffers from stale and incomplete data given its delisted status.