How I use Implied Cost of Capital (ICC) as a market valuation tool

What is Implied Cost of Capital?

In accounting and finance the implied cost of equity capital (ICC)—defined as the internal rate of return that equates the current stock price to discounted expected future dividends—is an increasingly popular class of proxies for the expected rate of equity returns.
— CHARLES C. Y. WANG; an assistant professor of business administration in the Accounting and Management Unit at Harvard Business School

I love the intuition behind the model although I don't use it as proxy for expected returns. I use it as a relative value measure to identify analyst/institutional sentiment between different market sectors at a point in time. 

The actual calculation of the measure can be somewhat complex and involved. The below equation is the common form of the ICC model.

As an active trader my primary concern is practical application and implementation so I simplified and streamlined the calculation as much as possible. 

I calculate the implied cost of capital for S&P SPDR ETF's representing a diverse cross section of sectors and industries. I calculate a simplified version by using the following process:

  1. I calculate an implied book value of equity per share, by taking the most recent ETF closing price and dividing by the given Price to Book ratio.
  2. I calculate an implied 1 yr forecast estimate of EPS by dividing the last ETF closing price by the given 1 yr forward P/E ratio.
  3. For the sake of brevity I then make a gross assumption by setting the current implied BV of equity equal to last year's BV of equity.
  4. I then use the median ETF price over the most current month, and assume a long term growth (g) of 5% for use in calculating a terminal value. 
  5. I then estimate the ICC using 2 methods.
    • I use the formula shown above and solve for 'R' which is the ICC estimate
    • I simplify the above equation into a simple capital budget style IRR function. I use a negative current median price as the initial cash outflow, assume a holding period of 1 year, and then I assume at the end of that 1 year holding period we are able to sell our stock for the price we paid plus next year's estimated earnings per share.

Again I make a LOT of dubious assumptions for the sake of simplicity, but to reiterate I'm using the metric as a relative value indicator and NOT a proxy for expected returns. My goal in looking at the various sectors is to try and identify which areas of the market are priced at relative extremes (discounts/premiums) compared to analyst forecasts' and current market sentiment. 

The 'sanity check' if you will can be found by looking at the extremes. You would expect the ETF's with the lowest ICC to have had relatively large appreciation of price relative to EPS forecasts. For example ( XBI ) the biotech ETF, ( XHE ) health care equipment ETF, and ( XPH ) the pharmaceutical ETF have seen their share prices advance significantly over the past several months. At the other end of the spectrum you would expect the opposite and for the most part you see that too. ( XME ) the metals and mining ETF, ( XES ) the oil and gas equipment & services ETF have seen their share prices crushed. And as a barometer of the market overall you would expect to see ( SPY ) somewhere in the middle perhaps towards the lower end of ICC estimates due to the continued appreciation of the US stock market overall. Guess what? If you examine the data you find ( SPY ) where we would expect it, modestly priced at 13.5% somewhere in the lower middle range.

Where the metric is interesting is in the edge cases. For example ( KIE ) the insurance ETF has a relatively large ICC measure. However, a quick glance at the chart shows a relatively volatile range with a clear positive trend channel. So what gives? That implies the sector overall may be undervalued as EPS forecasts are either unchanged or still relatively optimistic in comparison to the modest stock gains of the ETF.  If you are fundamental investor/value investor the relative ICC can give you insight into where you should focus your search. 

I'm considering posting this metric either weekly or bi-weekly. I'll think on it some more. Until then, feel free to comment, question or provide feedback.