4. Which of the three methods – CAPM, DDM, or ECM — is best for calculating the cost of equity? We can see that the three different methods of calculating the cost of equity produced widely varied estimates. In such situations the financial analyst has to use his/her judgment as to relative merits of each estimate and then choose the estimate which seemed more reasonable under the circumstances.
Comparing the already discussed methods, we found that the main advantage of CAPM approach is that it takes into consideration a company’s market risk as the most relevant risk to stockholders, hence to determine the effect of the new activities and projects of the company on stock price. This method can be applied to firms that do not pay dividends as well as new firms, by using betas for similar firms (e. g. , other firms in the industry). However, with CAPM all our projections are based on historical data onto the future, because of the estimate of Beta we use.
Also, CAPM is based on simplifying assumptions about markets, returns and investor behavior. The dividend discount model (DDM) is a simple model for valuing equity. It is considered to be a good thinking exercise as it forces the investors to begin thinking about different scenarios in relation to how the market is pricing the stock. On the other hand, dividend discount model requires an enormous amount of speculation in trying to forecast future dividends. Meaning that a model is only as good as the assumptions it is based upon.
Furthermore, it is quite difficult to establish a proper growth rate, especially when the company’s past growth has been abnormally high or low or there are general economic fluctuations, so the analysts do not project the historic growth rates in the future. Finally there are no direct adjustments for risk in this method. The earnings capitalization model (ECM) is a simple model and easy to understand. However, it is considered poor in estimating equity costs for growing firms, so it is used as reasonable only for no growth firms.