Opportunity cost of capital (or Cost of Equity) is the return foregone by not investing in the second-best alternative. Let me explain it with the help of an example. Let’s say, a business generates a return of 10% p.a. for its owners (Return on equity). Meanwhile, assuming bank fixed deposit rates are 7% p.a. Had the owners invested their money in a fixed deposit instead of the business, they would have earned only 7%. But because they invested their money in the business, they could earn an additional 3%. Here, 7% return on fixed deposit being the second-best alternative, is their opportunity cost of capital.
For any person to justify doing a business, its return on equity should at least be equal to its cost of equity, preferably higher.
This concept is also applicable in the stock selection process. Equity shareholders are nothing but part owners of the company. In order for them to invest in a company, its Return on Equity should at least be equal to their cost of equity. We can easily calculate the Return on Equity of a company by looking at its financial statements (Profit after tax/Shareholders funds). Now in order to make a decision on whether to invest in the company or not, we need to know the cost of equity (returns from the second-best alternative). Fixed deposit returns, however, cannot be considered to be the second-best alternative since it does not incorporate the risk associated with equity investments. We need to look at something which incorporates this risk.
Nifty 50 Index returns do incorporate this risk and hence can be considered for the purpose of calculating opportunity cost of equity. Since Nifty ETFs closely mimic the Nifty index returns, they can be used as their proxy. Now, in order to ascertain the cost of equity, we will have to calculate the returns that a Nifty ETF has delivered historically. For this purpose, I have calculated 10-year rolling returns (CAGR) of – ‘Nippon India ETF Nifty BeES’ from FY02 to FY20. The excel file is attached below.
As we can see, this Nifty ETF has returned approximately 12.5% (assuming 10-year period). And hence we can safely assume 12.5% to be the cost of equity. Any company consistently earning less than 12.5% ROE is a bad investment for its equity shareholders since they could have instead invested in a Nifty ETF.
Closing NAVs have been sourced from – https://www.nseindia.com/get-quotes/equity?symbol=NIFTYBEES