How to Calculate Cost of Equity?

Cost of equity is a concept of finance which involves estimating the returns that a company must offer its shareholders for the investment they made in the company.

 

Table of Contents

• Concept of Cost of Equity
• How to Calculate the Cost of Equity?
• Significance 
• Applications

Concept of Cost of Equity

When you buy shares in a company, you are lending money to that company. This investment is without any guarantee of profit. The higher the risk, the higher the expected returns. It is important to understand the cost of equity to make informed decisions about raising funds. Cost of equity is a benchmark for a company's performance. The cost of equity calculation is important for a company to generate higher returns than the cost of equity. It is a key component applied in valuation models such as the Capital Asset Pricing Model (CAPM) and Dividend Discount Model to determine the fair value of a company's stock. This is essential for investors as well as companies.

How to Calculate the Cost of Equity?

Let us start with the formula to calculate the cost of equity:

1, Using CAPM

First, let us calculate the cost of equity using CAPM. We do not subtract the capital asset pricing model CAPM. Rather we use CAPM to calculate equity cost.

E(Ra) = Rf + βa * [E(Rm) – Rf]

Here the above terms symbolize the following:

• E(Ra) Expected Return on Asset a: This is the return that investors expect to earn from their investment in a particular asset (like a stock). It's not a guaranteed return but rather an estimate based on various factors, including the risk of the investment.
• Rf Risk-Free Rate of Return: This is the return expected from an investment with zero risk. Typically, this is the yield on government treasury bonds, like U.S. Treasury bonds. These are considered "risk-free" because they are backed by the government and are very unlikely to default.
• Βa Beta of Asset a: Beta measures the volatility or risk of asset a relative to the overall market. A beta of 1 means the asset's price moves with the market. Beta greater than 1 represents that the asset is more volatile than the market (i.e., it amplifies market movements), while a beta less than 1 means it's less volatile. For example, a beta of 1.5 suggests that if the market goes up by 10%, the asset is expected to go up by 15%, and vice versa.
• E(Rm) Expected Market Return: This is the average return expected from the market as a whole, often based on historical returns of a financial market index like the S&P 500.
• [E(Rm) – Rf]: This term represents the market risk premium. It is the additional return investors expect for taking on the higher risk of investing in the stock market over a risk-free investment. It is calculated by subtracting the risk-free rate from the expected market return.
  

Explore investing courses

Let us assume that you are analyzing a technology company to decide whether to invest in it. To calculate the cost of equity, you will gather the following information:

• Risk-Free Rate (Rf): The current yield on 10-year government bonds is 3%. This will be our risk-free rate.
• Beta of TechCorp (βa): Company's beta is 1.2. This means the company's stock is 20% more volatile than the market.
• Expected Market Return (E(Rm)): Based on historical data, you expect the overall stock market to return 10% annually.

Now, let us use the CAPM formula to calculate the expected return on the company’s stock, which is also the cost of equity for the company.

E(Ra) = Rf + βa * [E(Rm) – Rf]

E(Ra) = 3% + 1.2 × (10% − 3%)

= 3% + 1.2 x 7%

= 3% + 8.4% 

= 11.4%

It means that to attract equity investors, the company should at least provide a return of 11.4% to shareholders on their investment, considering the risk involved.

2. Using Dividend Capitalization Model 

Dividend Capitalization Model or Dividend Discount Model applies only to those companies that pay dividends. While applying this formula, it is assumed that the dividends will grow at a constant rate. This model does not consider investment risk to the extent that CAPM does.

Cost of Equity = (Dividend per Share next year/ Current Market Value of Stock) + Growth Rate of Dividends

Suppose a company's current stock price is $100, it is expected to pay a dividend of $4 per share next year, and the dividends are expected to grow at a rate of 5% per year. The cost of equity would be calculated as follows:

• Expected Dividend per Share for Next Year (DPS): $4
• Current Market Value of Stock: $100
• Growth Rate of Dividends (g): 5% or 0.05

Cost of Equity = (Dividend per Share next year/ Current Market Value of Stock) + Growth Rate of Dividends

= $(4/100) + 0.05

= 0.04 + 0.05

= 0.09 or 9%

The cost of equity for the company is 9%  as calculated using the Dividend Capitalization Model.

Significance For Companies as Well as Investors

Cost of equity is an important financial concept that anyone running the company or an accounting professional must be aware of while dealing with the finances of the company.

For Companies

1. Benchmark for Investment Projects: The cost of equity serves as a benchmark for evaluating the profitability of investment projects. A company should ideally undertake projects that offer a return higher than the cost of equity, ensuring that these projects add value to the shareholders.
2. Capital Structure Decisions: Cost of equity helps a company in making decisions about its capital structure, i.e., the mix of debt and equity used to finance its operations. A high cost of equity might lead a company to use more debt financing if it's cheaper, but this must be balanced against the risk of taking on too much debt.
3. Performance Indicator: It acts as a performance indicator. If a company's return on equity is lower than its cost of equity, it may indicate that the company is not generating sufficient returns for its shareholders, potentially leading to a decrease in stock value.
4. Pricing of Shares: When issuing new shares, a company must consider its cost of equity to price its shares appropriately. Setting the price too low might undervalue the company, while setting it too high could lead to under-subscription.
5. Signal to Market: The cost of equity can signal to the market how risky the company is perceived to be. A higher cost of equity often indicates higher perceived risk, which can affect the company's reputation and its ability to raise capital.
   

Explore accounting courses

For Investors

1. Investment Decision Making: For investors, the cost of equity is a crucial component in determining whether to invest in a particular stock. It helps in assessing whether the expected return on a stock compensates for the risk taken.
2. Portfolio Management: Investors use the cost of equity to assess the risk-return profile of their portfolio. It helps in diversifying their investment and in choosing a mix of assets that aligns with their risk appetite.
3. Valuation of Stocks: The cost of equity is used in various valuation models, like the Dividend Discount Model (DDM) and Discounted Cash Flow (DCF) analysis, to estimate the fair value of a stock. This helps investors in making informed decisions about buying or selling stocks.
4. Risk Assessment: The cost of equity reflects the risk associated with a particular stock, especially through the beta component. Investors use this to gauge the stock's volatility and its correlation with market movements.
5. Return Expectations: It sets the benchmark for the returns investors expect from their equity investments. If the actual returns are consistently below the cost of equity, investors might reconsider their investment in favor of better-performing assets.

Applications for Equity Cost

The cost of equity is a concept in finance and has several important applications in both corporate finance and investment analysis. Here are some of the key applications:

1. Capital Budgeting: Companies use the cost of equity to evaluate the feasibility and profitability of investment projects. Projects with expected returns greater than the cost of equity are typically considered value-adding and may be pursued.
2. Performance Measurement: The cost of equity serves as a benchmark for assessing a company's performance. If a company's return on equity exceeds its cost of equity, it indicates that the company is generating sufficient returns to compensate its shareholders for the risk they are taking.
3. Stock Valuation: In investment analysis, the cost of equity is used in various valuation models including Dividend Discount Model (DDM) and Discounted Cash Flow (DCF) model. This is relevant for determining the intrinsic value of a stock.
4. Determining Capital Structure: The cost of equity is a critical factor in determining a company's optimal capital structure—the combination of debt and equity financing. A higher cost of equity might incentivize a company to increase its use of debt financing, provided the cost of debt is lower.
5. Setting Financial Targets: Companies often set financial performance targets based on their cost of equity. These targets can guide strategic and operational decisions to ensure that the company delivers value to its shareholders.
6. Risk Management: Since the cost of equity reflects the risk associated with a company’s equity, it helps in understanding and managing the risk profile of the company. Companies might take steps to reduce their cost of equity by lowering business risks.
7. Mergers and Acquisitions: In M&A activities, the cost of equity is used to evaluate the financial attractiveness of potential acquisition targets. It helps in determining the maximum price that should be paid for an acquisition.
8. Investor Communication: By understanding and communicating its cost of equity, a company can better explain to its investors the risks and returns associated with investing in its stock.
9. Portfolio Management: For investors, particularly in portfolio management and asset allocation, the cost of equity is used to assess the expected return on equity investments and to build a portfolio that aligns with their risk-return objectives.
10. Regulatory Purposes: In some regulated industries, the cost of equity can be a factor in determining the rates that companies charge their customers, especially in utilities and energy sectors.

Explore capital budgeting courses