Cost of Equity

To estimate the cost of equity, Domino’s used the Capital Asset Pricing Model (CAPM) which was a widely used methodology in the industry. Application of the CAPM required several inputs including: the risk-free rate, the beta and the market risk premium.

1. The risk-free rate

The risk-free rate reflected a return that was free of any risk, the most important of which was default risk. For this reason, a common measure of the risk-free rate was the interest rate (or yield) on a long-term government debt security. In Australia, the convention was to use the yield on 10-year Treasury bonds issued by the Commonwealth Government of Australia.

Exhibit 6 presented the yield on 10-year T-bonds for each month in 2023.

Exhibit 6: Yield on 10-year T-bonds

Source: Statistical Tables | RBA

2. Beta

Beta measured the systematic risk of a company and affected the required rate of return on equity. Domino’s measured its beta using regressions from its stock returns and market returns. However, its analyst team was also aware of the shortcomings of this approach that relied on historical data and typically cross-checked the beta obtained from a market model regression against an analyst estimate of beta that also considered the industry beta.

Regression using historical data

To estimate beta using a regression, a series of market returns and Domino’s returns were required. While beta can be time varying depending on the time window over which returns were calculated, it was a common practice at Domino’s to use a 5-year window of monthly data. Once the market and Domino’s returns were obtained, beta could be estimated using the SLOPE function in Excel.

Exhibit 7 detailed the monthly adjusted close price for Domino’s for the 5-year window ending December 2023. The adjusted price considered the effects on stock splits and dividend payments, thus provided a better indicator of total return. Similarly, the S&P ASX200 accumulation index was used to calculate market returns including reinvested dividends. This index tracked the performance of the top 200 companies listed in the ASX.

Exhibit 7: Monthly adjusted close price for Domino’s for the 5-year window ending December 2023

Source: https://au.finance.yahoo.com and https://au.investing.com/

Industry-adjusted Beta

The analyst team at Domino’s also referenced their own estimated beta against an industry-adjusted beta that was provided by Morningstar DatAnalysis. Morningstar approach was to calculate a company beta by taking the industry average beta and adjusting it for each company based on its financial leverage (D/E). Morningstar estimates of company betas hence changed as the industry average (supplied by the Centre for Research in Finance at the Australian Graduate School of Management) and/or a company financial leverage changed.

As of 30 December 2023, the estimated beta for Domino’s was 0.94 against an industry beta of 1.03.

3. The equity market risk premium

The equity market risk premium measured the extra return that investors expected to receive as they invested in a risky market portfolio in excess of the risk-free rate. The market risk premium could be mathematically expressed as Rm – Rf where Rm is the expected return from a market index such as the S&P ASX200 and Rf is the risk-free rate commonly proxied by the yield on the 10-year T-bonds.

Domino’s estimated the market risk premium from their own data as well as using a common industry market risk premium. For example, both KPMG[1] – a global audit and advisory company and Leadenhall[2] – a leading Australian independent corporate advisory firm recommended an equity market risk premium of 5.5% as of December 2023.