THE COST OF EQUITY OF TOO BIG TO FAIL BANKS (TBTF). A COMPARATIVE STUDY BETWEEN CAPM, THE METHOD BASED ON THE RECIPROCAL OF P/E MULTIPLE AND ACTUARIAL METHOD

The cost of equity is typically defined as the expected return that investors require to purchase common stock in a firm. It is therefore an important input for bank management when raising capital and making investment decisions and for investors when they value equity securities and construct their portfolios. The Capital Assets Pricing Model (CAPM) method remains the one most commonly used by practitioners and financial advisers to estimate a firm’s cost of equity, as shown in surveys by Brunner et al (1998) and Graham and Harvey (2001). This paper provides a comparative analysis of different methods for determining the cost of equity according the following methods: the Capital Assets Pricing Model, the Actuarial Method, (Oricchio, 2012), based on the probability of default (PD) and finally the method based on the “price to earnings” multiple (P/E), (Zimmer and McCauley, 1991). This comparison has been carried out on 24 large international banks (the so called “Too Big to Fail”) from 2012 to 2014. The selected banks in the sample belong to eleven different countries. The first phase was aimed at measuring the risk premium of the banks through the use of the CAPM method. This model estimating the parameter of the risk premium as resulting from the product of beta coefficient and the equity risk premium (ERP). Beta factors, provided by the Datastream-Thompson Reuters Company, covered the period 2012 - 2014. The second phase determined the probability of default of the selected banks, for a period of three years, providing estimates on the basis of the credit rating of each financial institution analyzed. This method is based on the use of 10 years cumulative PD from the Moody’s database. Finally, the “cost of equity” of selected banks was measured through the alternative approach based on the reciprocal of the multiple “price to earnings”. However, an important assumption needs to be introduced in order to use this method for estimating a firm’s cost of equity. This is that the current profit rates represent a good estimate of the expected long-term sustainable ones. These three methods have been used during the overall analysis process, exclusively focusing on market data, and through these data it has been possible to estimate “the cost of equity”. 10th Annual Conference of the EuroMed Academy of Business 2038 Global and national business theories and practice: ISSN: 2547-8516 bridging the past with the future ISBN: 978-9963-711-56-7 A comparison has been carried out between three models in the following way: - Determining the difference between the values obtained by CAPM method and the values resulting from the use of Actuarial Method; - Determining the difference between the values obtained by CAPM method and the values resulting from the use of reciprocal of “price to earnings” multiple (P/E). The trends of cost of equity, calculated with the three methods, were observed, and after such analysis, the results have been examined and possible differences of values have been explained.