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Measuring and interpreting the cost of equity in the euro area

Author

Listed:
  • Geis, André
  • Kapp, Daniel
  • Kristiansen, Kristian

Abstract

Equity capital is among the main sources of funding for euro area non-financial corporations (NFCs), making it an important factor in the transmission of monetary policy. From a central bank perspective, improving the measurement and understanding of the cost of equity is therefore essential. Unlike the cost of debt, which has declined substantially in recent years, the cost of equity has remained relatively stable at elevated levels. Results from the analysis performed in this article suggest that a persistently high “equity risk premium” (ERP) has been the key factor underpinning the high cost of equity for euro area NFCs. In fact, since the start of the global financial crisis, increases in the ERP have largely offset the fall in the yield of risk-free assets. This article argues that the widely used workhorse model to derive the cost of equity and the ERP, namely the three-stage dividend discount model, can be improved upon. In particular, incorporating short-term earnings expectations, discounting payouts to investors with a discount factor with appropriate maturity, and considering share buy-backs all yield beneficial refinements. This in turn would strengthen the theory and basis of the model and improve the robustness of its estimates. Most notably, share buy-back activity seems to matter, specifically for the level of the ERP. Notwithstanding such improvements in the modelling approach, estimating the ERP, particularly its level, remains subject to considerable uncertainty. Ultimately, such uncertainty advocates the use of a variety of models and survey estimates, as well as a focus on the dynamics, rather than on the level, of the ERP. From an applied perspective, the article demonstrates that cost of equity modelling can be used to disentangle the different drivers of changes in equity prices. This is helpful from a monetary policy perspective, as changes in equity prices can contain important information about the economic outlook and warrant monitoring for financial stability purposes. Moreover, the article shows that adding an international perspective to the analysis of the ERP for the overall market may provide valuable insights for policymakers. For instance, the greater reliance on share buy-backs among companies in the United States than those in the euro area appears to be behind some of the recent steeper decline in the ERP in the United States when compared with the ERP in the euro area. JEL Classification: E52, G12, G32, G35

Suggested Citation

  • Geis, André & Kapp, Daniel & Kristiansen, Kristian, 2018. "Measuring and interpreting the cost of equity in the euro area," Economic Bulletin Articles, European Central Bank, vol. 4.
  • Handle: RePEc:ecb:ecbart:2018:0004:2
    Note: 504004
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    File URL: https://www.ecb.europa.eu//pub/economic-bulletin/articles/2018/html/ecb.ebart201804_02.en.html
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    Citations

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    Cited by:

    1. Kapp, Daniel & Kristiansen, Kristian, 2021. "Euro area equity risk premia and monetary policy: a longer-term perspective," Working Paper Series 2535, European Central Bank.
    2. Roland Meyer & Gert Brunekreeft & George Elias, 2020. "TOTEX Malmquist index for CPI-X regulation: Does it correctly estimate the true frontier shift?," Journal of Regulatory Economics, Springer, vol. 58(1), pages 78-97, August.
    3. Kristiansen, Kristian & Hvid, Anna Kirstine, 2020. "How news affects sectoral stock prices through earnings expectations and risk premia," Working Paper Series 2493, European Central Bank.
    4. van Wijnbergen, Sweder & Olijslagers, Stan & de Vette, Nander, 2020. "Debt sustainability when r - g," CEPR Discussion Papers 15478, C.E.P.R. Discussion Papers.
    5. Ciccarelli, Matteo & Darracq Pariès, Matthieu & Priftis, Romanos & Angelini, Elena & Bańbura, Marta & Bokan, Nikola & Fagan, Gabriel & Gumiel, José Emilio & Kornprobst, Antoine & Lalik, Magdalena & Mo, 2024. "ECB macroeconometric models for forecasting and policy analysis," Occasional Paper Series 344, European Central Bank.
    6. Sweder van Wijnbergen & Stan Olijslagers & Nander de Vette, 2020. "Debt sustainability when r - g smaller than 0: no free lunch after all," Tinbergen Institute Discussion Papers 20-079/VI, Tinbergen Institute.

    More about this item

    Keywords

    asset pricing; capital and ownership structure; financing policy; monetary policy; payout policy;
    All these keywords.

    JEL classification:

    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill
    • G35 - Financial Economics - - Corporate Finance and Governance - - - Payout Policy

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