[Bloomberg] Why the Expected Market Return is sensitive to the current price?

The worldwide index price has fluctuated recently, and we noticed that the WACC (of specific equity) calculated on Bloomberg has oscillated as well. It aroused our interest to find out the possible explanation behind it.

Comparing to the cost of equity, cost of debt is comparably stable. So we focus on the cost of equity and check the formulas as bellow. (The formula is based on the Bloomberg WACC page, which might stands for the possible theory that Bloomberg adopts.)

Cost of Equity = Risk Free Rate + Equity Risk Premium

Equity Risk Premium = Beta * Country Premium

Country Premium = Expected Market Return - Risk Free Rate

Among the above three formulas, there are only three variables, Risk Free Rate, Beta and Expected Market Return. Risk Free Rate is a selected reference and Beta depends on the liquidity of the equity, so here we will only discuss the remaining variable, Expected Market Return.

There are several theories to forecast the Expected Market Return. After several approaching and guessing, we found that Bloomberg may use Dividend Discount Model (DDM) to forecast the Expected Market Return. They use the estimated dividend payout rate and growth rate to predict the future dividend first. Then, use the current share price and future dividend to calculate the IRR of each company. Lastly, the weighted average the IRR as the Expected Market Return.

Based on this method, the IRR will be extremely sensitive to the current price. Therefore, the Expected Market Return, Equity Risk Premium, Cost of Equity and even WACC will be indirectly affected by the market price significantly if the market fluctuated as recently. (US stocks were affected by the virus and the Fed between late February and early March 2020.)

*Note: Bloomberg considers the formula of Expected Market Return as confidential information. Thus, all the discussion here is all come from our guessing and for discussion only.