Over the short term, a company's cost of capital may seem like an immovable object that cannot be reduced without the most strenuous efforts. However, a public company can reduce its cost of capital merely by altering the message it sends to the investment community. It does this by targeting a specific component of the cost of capital calculation.
A subset of the cost of capital is the cost of equity, which is determined by using the capital asset pricing model (CAPM). The CAPM essentially derives the cost of equity by determining the relative risk of holding a company's stock as compared to a mix of many stocks. This risk is comprised of three elements, which are (1) the return from a risk-free investment (such as a U.S. government security); (2) the return from a set of securities considered to have an average level of risk; and (3) a company's beta.
The beta is our instrument for reducing the corporate cost of capital. The beta defines the amount by which a specific stock's returns vary from the returns of stocks with an average risk level. This information is generated by several of the major investment services, such as Value Line. For example, a beta of 1.0 means that a specific stock is exactly as risky as the average stock, while a beta of 0.4 represents minimal stock price volatility, and 1.5 indicates considerable volatility. In brief, a high beta drives up the cost of equity, which in turn increases the cost of capital. Our objective is to take those steps necessary to reduce the company's beta, thereby shrinking its cost of capital.
Beta is based upon the amount by which a company's stock price moves up or down over a period of time (volatility). A key reason for excessive volatility is uncertainty in the marketplace regarding a company's financial results and future expectations. If investors have little knowledge about a company, then their perceived valuations of it may vary wildly, leading to massive price swings. The solution is to create a structure for feeding a consistent flow of conservative information into the market. Here are some steps to consider:
- Issue a quarterly earnings release through a major news service, such as Business Wire or PR Newswire. This should be timed to immediately follow the quarterly 10-Q filing, and should include the Management Discussion and Analysis section of the 10-Q.
- Schedule a quarterly earnings conference call, timed to follow the quarterly 10-Q filing. This is more important than issuing an earnings press release, since callers can ask questions of the management attendees; this is an opportunity for management to expand upon the information previously issued.
- Include in the conference call and earnings release a statement regarding the company's expectations for future results. When issuing this information, always provide a conservative slant to the presented guidance. This topic is addressed more thoroughly in the companion article Providing Guidance.
- Schedule periodic non-deal road shows to discuss the company's results and prospects with investors and analysts.
By taking all of these steps, a company floods the market with a consistent, conservative message about its historical and expected results. Once all members of the investment community have the same information, they are far more likely to assign a target price to its stock that falls within an extremely narrow range. This results in significantly less stock price volatility, a lower beta, and therefore a lower cost of capital.
In addition, volatility may simply be caused by having too small a number of shares available for trading. If so, take all necessary steps to register additional shares, as well as to compress multiple types of stock into a single type of common stock. Further, shift trading onto an organized exchange, such as the American Stock Exchange or NASDAQ, which tends to increase the daily order volume.
What if a company implements all of the actions described here, and finds that its published beta has not budged? The reason is that beta is calculated based on historical volatility; some investment services firms calculate beta based on multi-year historical results, so it may be some time before the beta declines by a significant amount. If the CFO is in a rush to obtain a more accurate beta information, then either calculate it in-house or shop around among investment services firms to see who calculates beta using the shortest time horizon.