Equity Valuation: Premium to Interest Rate Structure Model

Abstract

Among the Equity Valuation models, the Discounting of cash flow (DCF) uses the cost of equity capital as a discounting rate in determining the value of equity. The cost of equity capital is usually calculated using the CAPM. The capital asset pricing model is backward looking as its components like beta and risk premium are based on the historical data. Most factor models used in academics and in practice consider historical data of stock returns and index to determine the cost of equity. The stock price which reflects the present value of future cash flows cannot be completely based on historical data for discounting. This paper proposes a modified model of DCF which takes into account a forward looking cost of equity capital. The model will include the time dynamic changes in the components of the cost of capital as opposed to those with time static components. It is proposed to use the forward looking risk free rate, obtained through bootstrapped spot curve, to which the forward looking time dynamic risk premium times the forward looking beta is added in order to arrive at the cost of equity. This forward looking cost of equity is then used for discounting of the estimated future cash flows to arrive at the value of the stock.