Interview - A New Era of Growth for the U.S. Economy

Charles G. Callard

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Charles Callard is Founder and President of Callard Research, a leader in the practical application of cutting-edge academic theory to real-world financial management. A recognized authority in the investment management field, Chuck has written and lectured extensively on valuation methods and performance measurement.

VS: Your latest research suggests that profitability is becoming less important for corporations than it's been in the past. What exactly do you mean by that?

CC: It's all about the Cost of Capital. The cost of equity capital over the next decade and beyond will be something like half what it's been for the last 80 years. Major US corporations have historically faced a 7-8% Cost of Capital, in real terms. Today that number's more like 4%. In this kind of environment, the stock price is more affected by a company's ability to expand its investments - R&D, employees, and so forth. Hitting the old accounting targets, like ROE (Return on Equity) and ROI (Return on Investment) becomes less important, especially if it means turning down attractive investments just to keep the ROE numbers up. You're going to see a period in which the firms which have historically delivered high ROE's will continue to attract new capital, but their ROE's will drop as they invest in projects which they wouldn't have done back when the Cost of Capital was higher.

VS: How did you make that prediction?

CC: The real question is, how do you measure the Cost of Capital. You start by asking what level of return must investors earn in order to keep funding economic growth. That number, around 2½% real (after-tax), has been stable for over a century. Then you do the arithmetic to figure out what the investor must earn pre-tax to achieve it. (The investor's pre-tax return is equivalent to the corporation's after-tax earnings.) The calculations are a bit complicated, but there's nothing magical about them. You need to factor in marginal tax rates, capital gains rates, inflation expectations, and so forth. That's where the basic numbers come from.

That's all well and good, but it isn't worth much unless it works. This is where things start to get interesting. Finance 101 teaches that the value of a stock is the present value of anticipated earnings, discounted at the appropriate Cost of Capital. Applying this to individual companies is tricky - there's just too much uncertainty in the forecasts. Applying it to the equity market in general, let's use the S&P 500, is much easier. The earnings forecast for the S&P doesn't really fluctuate all that much. Even in a recession, the good results tend to offset the bad. The equation has three elements: price, earnings, and Cost of Capital. As long as you know two of them, you can solve for the third.

When you go back and apply this, you find that all the ups and downs in historical stock prices are accounted for by changes in the cost of capital. You have a relatively simple model, and yet it permits accounting for achieved shareholder returns over any holding period, whether three months or twenty years, during most of the past two centuries.

VS: This approach doesn't sound very much like the Capital Asset Pricing Model (CAPM)...

CC: No. It's fundamentally different because it's a forward-looking model. CAPM looks at what past returns have been, and assumes that those returns will continue into the future. It doesn't really address the question of why those numbers are what they are, or what might cause them to change. The S&P returned around 13% a year from the 1950's through 1965, then it was basically flat for the next fifteen years, then it returned around 12½% per year from 1980 through 1999. Do you really want to just average everything together and call that your Cost of Capital?

VS: What about debt?

CC: CAPM treats the debt and equity rates as two independent numbers. One problem is that the debt (interest) rate is a forward-looking number, and as we've seen, the equity rate is a historical number. When you look at the data, you find that the two rates are correlated and that the equity rate actually leads the debt rate. Interest rate forecasts are a whole other interview. The bottom line, is that debt rates are falling as well, for many of the same reasons as equity rates.

VS: So why is all this important?

CC: When the Cost of Capital is high, as it was during the 1930's and the 1970's, most companies have difficulty expanding, corporate earning shrink, and stock prices get marked down. When the Cost of Capital is lower the opposite happens. More companies can afford to expand, and the economy benefits as profits rise. A difference of even a few percentage points in the Cost of Capital makes a tremendous difference in the number of firms that can afford to expand.

VS: You did some interesting research ten or fifteen years ago…

CC: Yes, back then the Japanese firms were going gangbusters, and US firms were in the doldrums. Everyone thought the Japanese walked on water. It turned out it was simply that Japan was enjoying the benefits of a lower Cost of Capital. US firms were actually outperforming the Japanese, but since the US cost of capital was so high, it felt like we were losing. We were shutting plants, laying off workers, and losing market share. The Japanese firms, with their lower cost of capital, had an incentive to expand, and that's what they did. Even though from an operational standpoint, they weren't doing nearly as well as the US firms that were shrinking.

The Japanese had a 2.5% cost of capital then, but they changed their tax policies, their cost of capital rose, and all of that flip-flopped. That accounts for most of their enormous decline. Now Japan is where the US was in the late 1970's.