1. Cost of Equity Factors
Let's analyze some factors that affect the cost of equity for our business.
So what affects share prices? Well, there's two main categories, beta and
alpha. Beta is the market risk, and alpha is the firm specific risk.
Let's dive deeper to see examples of each.
On the market risk side, we have things like interest rates,
the business cycle and the stage of business development that the economy
is in, inflation, political or legislative impacts that are impacting business
and socioeconomic trends. On the other side, we have firm specific factors,
where we look at things like management, the profitability of the business
and the stability of those profits, the operations,
how consistent and reliable and effective are they,
the projects that the company has in progress and in the future that
it can execute, and the products and services that it offers to its
customers. So you can see how there's this delineation between the market
risk and the firm specific risk, and the key is to be able
to assess both of these and understand how they impact the future performance
of a company. And this is where the cost of equity seeks to
account for these things. But here's a crucial point,
if we as investors hold a diversified portfolio of stocks,
we effectively remove the firm specific risk and are only exposed to the
market risk to the stock, the beta.
2. Let's practice!