what do you think?

The paper was discussing about whether capital asset pricing model (CAPM) is the best way to predict cost of equity for lodging analysis and finding how another methods can be improved to in order to provide more reliable way in estimating cost of equity.  The result revealed that Price-forward- earnings (PFE) methods with implied cost of equity (ICE) approach is better estimating the result and having reliable result compared to CAPM.

The question that were raised is whether implied cost of equity (ICE) is belong to unsystematic risk or not, since there are two big classification of risk, which is systematic risk (Relates to the variability in the returns due to interest rate changes, inflationary changes, recessions and natural disaster, etc) and unsystematic risk (Relates to the variability in the returns from loss of a key manager, patents, strikes).  

Since the central principal of the CAPM is that systematic risk, as measured by beta, is the only factor affecting the level of return, so I assumed the author considered not only systematic risk, as they mentioned based on their literature studies on Botosan (1997); that revealed there are another factor that influence expected return, therefore Botosan used implied cost of equity (ICE).  It makes me concluded that PFE is belongs to unsystematic risk.

CAPM formula:

ERj = Rf + bj (ERm – Rf)

ERj   = the rate of return that investors require on security j

Rf     = the return on a risk-free asset

bj      = expected return on the overall market

ERm = the Beta coefficient for security j          

So, base on above formula, it is obviously mentioned that CAPM consider beta which is symbol for systematic risk

Another reason that explained during the discussion was the effectiveness of new method implemented in. As CAPM is  device for explaining how markets price capital assets and also explain how an efficient capital market sets a price on individual securities by taking into account their respective risks and the expected returns from holding them, but still the result from CAPM still considered not really significant. Therefore the author developed price to forward earning to make it more reliable.

 

 

 

 

 

 

 

                                               

Picture. Security market line

According to presenter, PFE methods can make the result more close to the security market line compare to CAPM result. This  were cited from the paper’s result.

Moreover, another question was whether price to forward earning (PFE) method also suitable for private companies instead of lodging industries. The presenter said it does be implemented in another industry, but they didn’t mention further. According to the literature, cost of equity can be estimated by using another method also, such as weighted –average cost of capital (WACC). The company’s WACC will be the discount rate that will be used to discount the expected future cash flows from their investments.

My comment is it was too complicated to use many methods in estimating cost of equity. The author mentioned 6 level of methods and all of them having different result. I was wondering if such particular methods were used to non-lodging industry, were it be produce different result also? Let say, the PFE is the best methods to estimate cost of equity for lodging industry, but were the result would be the same if I use non-lodging industry, and PFE is still considered as the best methods also?  

Advertisements