Solving the Human Capital Measurement Problem
Within the Capital Asset Pricing Model
Among the tasks of critical importance for corporate financial managers and venture capitalists is measuring the cost of equity capital for a company in question. However, this cost of equity estimation has been an elusive metric because the results are almost always subjective as certain equation parameters cannot be measured accurately.
This means that the Capital Asset Pricing Model (CAPM) is still questionable as a solid benchmark.
CAPM Explained (With Respect to Investors)
The capital asset pricing model (CAPM) shows how financial markets put pricing tags on securities in order to estimate expected returns on capital investments. The method provides a way to quantify risk and translates it into estimates of expected return on equity.
The CAPM formula is the following:
So, how does this work in terms of calculating investment opportunities?
Each investor wants to be compensated for the following two components:
In the CAPM formula, “Rf” (or the risk-free rate), accounts for the time value of money, while all the remaining CAPM equation components represent parameters where the investor is taking on additional risk.
The beta of a potential investment is another key component as it displays the amount of risk a certain investment will add to a portfolio. In a scenario where a stock is riskier than the market, the beta metric will have a value greater than one. But, if the beta is less than one for a particular stock, the CAPM equation suggests (or assumes) that the risk of a portfolio will be decreased. The beta of a stock gets multiplied by the market risk premium, therefore accounting for the return expected from the market above the risk-free rate. Then we add the risk-free rate to the product of the stock’s beta as well as the market risk premium.
This is how the CAPM formula is deployed to evaluate if a company is properly and fairly valued, especially in terms of comparing its risk and the time value of money to expected return. The end goal is to provide investors with the much-needed return or discount rate so they can determine the true value of a company.
CAPM and Its Problems
The system has been proven to work to a certain extent over the last several decades. There are even two Nobel prizes that belong to the persons who tackled this equation, one from 1990 and the other in 2014.
Now, the problem is that the CAPM is not as accurate as previously thought, with the famous Roll’s critique explaining why it is impossible to create or observe a truly diversified market portfolio.
According to Roll, a true value of the market portfolio is unobservable as it doesn’t (in practice) include every single possible available asset that also determines the stock value. These typically include real estate, precious metals, and other entities containing any worth, including the true cost of human capital.
This basically means that actual returns on all possible investments opportunities are unobservable and that the CAPM’s validity can be equated to the market being mean-variance efficient in terms of all investment opportunities. If one cannot accurately observe all investment opportunities, testing the mean-variance efficiency of any portfolio with high confidence is not doable, which means that testing the CAPM in an error-free manner is simply not possible.
The Elusiveness of the Human Capital Metric
One of the major obstacles for accurately measuring the CAPM is determining the value of Human Capital within a company in question. Since it is impossible to get a secure estimate on this metric, any CAPM testing process is basically useless as the human capital component accounts for a substantial chunk of a company’s market value.
And this is where it gets quite important to the readers who are looking for the correlation between human capital and investing. The CFOs of the biggest companies use the CAPM to calculate the cost of capital and cost of equity, even though the human capital factor is still unclear, which means that their calculations are not as accurate as they would prefer.
This accounts for a major issue when it comes to assessing investment opportunities from the venture capitalist and M&A standpoints. And this is where Osterus comes in.
Developing the Human Capital Measurement
Osterus is currently working on a solution for measuring the value of human capital more precisely. The solution is based on the concept of workforce analytics. By using our platform, companies and investors are able to get more granular data on the workforce structure of the businesses they are trying to assess, and in so doing, glean valuable insights into the human capital component of their potential investment.
When determining the value of a company, it is important to analyze education, work experiences, languages, skills, and other sections in employee resumes. This type of data can help you determine patterns and correlations within CVs and career paths of staff members so you can better understand what the internal success or risk factors are within a certain company.
Scope of our software capabilities and analytics include:
- Detailed insights and information about the people within the company, the country and the general economic environment.
- Comparison of other companies, which helps you find irregularities — thus enhancing the due diligence process.
- Analysis of your company workforce in comparison with other selected companies.
- Insights into every data point within the Human Capital scope.
How Osterus operates:
- We gather all the information of the company via Social networks or have you upload the CVs in our software.
- Our software will run all the analytics in the background and provide reports on the workforce.
- We provide detailed information about the market, encompassing also the economic climate of the country.
These insights are of great value to our clients as they can use our software to more precisely determine the true market values of companies, figure out the levels of growth potential, assess the value of and demand for employee portfolios on the market, detect which workforce members are most likely to climb the corporate ladder, or who is likely to leave the company soon, and so on.
The “Fog of War” of the Banking World
Now, as any VC or financial services company will tell you, there is a ton of data that needs to be considered before making a proper assessment of a company. Let’s take a peek into the world of banking for a bit by drawing a comparison line between N26 and Nubank. Ever since, 2019, N26 has hinted its strategy to hit the Brazilian market. After all, N26 reached half a million users in the first year. However, there is a massive competitor looming, and it’s called Nubank. While these large banks are crossing swords in the media and perhaps one day on the market, some facts about human capital may easily go amiss in the ever-dense “fog of war.”
Bear in mind that the quality and value of a company isn’t necessarily measured by its financial performance or how they come across as in the news. Regardless of image, or how successful a company becomes, it’s almost always down to the people behind it. Utilizing Osterus as a workforce analytics software we can intuitively determine just how experienced individuals are, and how long they’ve been polishing their skills within their respective fields of expertise. Clearly, quite a large number of employees at Nubank spent more years in their professions (in this particular case, Customer Service), as opposed to N26.
What’s more, it’s interesting to note that in N26 5,73% of Customer Service Worked in Booking.com, 1.98% of Information Technology worked in Epam Systems Nubank, 0,51% of Customer Service worked in “99,” and 0,47% of Information Technology worked in “99.”
The Smooth Journey to That Home Run Investment
In a nutshell, when you start assessing a company through cold, hard numbers, it’s usually hard to see clearly, especially when the data stems from many sources. Using precise workforce data, Osterus effectively helps you overcome the challenges of human capital risk. The end result is easily bridging the gap between the goals of an organization and the skills of its workforce. Think of Osterus as your personal workforce assessment pocket calculator, or your very own Bloomberg Terminal for workforce data.
That data you’ve seen is but a tiny grain of what you can get if you’re using Osterus for your investment endeavors.
Feel free to schedule a demo and we’ll explain how this can become your reality.