This webpage discusses how to use the price to book ratio to evaluate the the cost of capital as a real alternative to the CAPM. I demonstrate how you can use the formula P/B = (1-ROE)/(1-Cost of Capital) to derive the cost of capital and how to consider situations were growth and cost of capital change. I also show how you can create a regression analysis of price demonstrates that you can use creative alternatives to the CAPM through making a regression analysis of market to book ratios and deriving the cost of capital from P/E ratios or EV/NOPAT ratios. I go a little crazy when finance professors make very general statements about the cost of capital being computed from financial ratios without any discussion of how this can be implemented in practice. In this page I hope to allow you to see how it can really be done. There are a couple of files that will be used in my explanation. These are attached to the buttons below.

The set of videos is supposed to suggest practical alternatives even though regression analysis of price to book ratios is presented and statistical analysis of beta is discussed. The videos and files generally demonstrate that CAPM overstates the cost of capital. In addition, the corrected value driver formula is used to evaluate the cost of capital. The lesson includes two files that illustrate the theory of coming up with cost of capital from the P/E formula and the P/B formula and also a database to compute the cost of capital using a lot of different methods. Both the data analysis and the theory are quite advanced and not consistent with traditional methods to evaluate the cost of capital.

Cost of Capital Subject | File Reference | Video Link | ||

Cost of Captial Database Introduction | Dow 30 Companies | https://www.youtube.com/watch?v=MOpSVBstv4o | ||

Cost of Capital Sensitivity Analysis Using the P/E Ratio Formula | Price to Earnings Analysis | https://www.youtube.com/watch?v=A5FoWknb0HM | ||

P/E Cost of Capital and Scenario Reporter | Scenario reporter | https://www.youtube.com/watch?v=j5DOUe6Wqbk | ||

P/E ratio and Cost of Capital with Transition and Interpolation (Number 6) | Interpolate and Lookup | https://www.youtube.com/watch?v=XLVqKfvmjCM | ||

P/B Regression Simulations for the Cost of Capital (Number 5) | Price to Book | https://www.youtube.com/watch?v=bhYlYSSWDVw | ||

P/B Formulas and Cost of Capital | Price to Book | https://www.youtube.com/watch?v=s2NdJs8Su44 | ||

Demonstration of Problems with CAPM | Beer Companies Database | https://www.youtube.com/watch?v=PL0zOQe-_6c | ||

Collecting Data with Ticker Symbols | Cost of Captial Database | https://www.youtube.com/watch?v=MTskVI_VERk | ||

Building Cost of Capital Data with Indirect Function | Cost of Captial Database | https://www.youtube.com/watch?v=UBl_pAvxhbs | ||

Problems with Beta and Measuring Cost of Capital | Renewable Stock Price | https://www.youtube.com/watch?v=eTDjLjZo9cE | ||

Use of Market P/E Ratio to Derive Cost of Capital | Economy Wide Cost of Capital | https://www.youtube.com/watch?v=GAolSYR1-pc | ||

DCF Model for Deriving Cost of Capital | Integrated Electricity Model | https://www.youtube.com/watch?v=9rsxSVDbjxE | ||

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**Files Used in Advanced Valuation Concepts Lesson Set 1: Using Methods other than CAPM to Estimate the Cost of Capital**

There are two general sets of files associated with the cost of capital analysis. The first set of files in the cost of capital set work through the theory of valuation and alternatives to the CAPM.

The second set of files show how the models work with real market data. The set of files and videos below include both development of spreadsheets that measure the theory and explanation of how to construct comprehensive financial ratio databases that can be automatically uploaded to evaluate cost of capital.

Deriving the cost of capital from the P/E ratio requires a lot of assumptions about long-term ROE versus cost of capital, long-term growth, inflation rates and transition periods. The P/E ratio files and videos use alternative scenario analyses to demonstrate the difficulty. The P/E Analysis file below evaluates the cost of capital with sensitivity and scenario analysis. It demonstrates how to correct the value driver formula P/E = (1-g/ROE)/(k-g) for inflation and changing returns.

Price to Earnings Analysis.xlsm

Cost of Capital and PE formula.xlsm

Price to Book Analysis.xlsm

This files below evaluates the price to book ratio analysis with regression analysis and shows how to develop the formula: PB = (ROE-g)/(k-g). It shows how you can use the market to book ratio to compute cost of capital and it demonstrates how a regression equation for the market to book ratio can be used to evaluate the cost of capital. If the CAPM is a biased and flawed model, bizarre attempts to adjust the cost of capital for country risk resulting in premiums as much as 11% for some countries. These CAPM derived premiums published by a man named Mr. Damoradan and frequently used have to imply that the real cost of all sorts of products ranging from houses to electricity can be as much as double for so-called risky countries.

1. Dow Stocks.xlsm

3. Utility Companies.xlsm

1. Beer Companies.xlsm

The database evaluates historic market to book ratios relative to projected return on equity to evaluate cost of capital. In addition PE ratios and published growth estimates are used along with assumed transition rates to back into the cost of capital. The CAPM is also computed along with the dividend discount model. The next set of videos explain the theory behind using the market to book ratio and the P/E ratio using simulation and sensitivity analysis. The final set of videos in the set explain details of how to build the data base.