The cost of equity is an important financial concept used in multiple calculations and for various purposes. Companies and investors use it to assess the viability of projects or investments. It represents the rate of return that a company pays equity investors and is one of the components in the calculation of the cost of capital, together with the cost of debt.
In this post, you will learn about the cost of equity, why it is important, and how it relates to the cost of debt and the cost of capital. You will also learn how to calculate the cost of equity using two different methods: the Capital Asset Pricing Model (CAPM) and the dividend capitalization model.
To learn more about the cost of debt and the cost of capital, check out the posts below.
What is the Cost of Equity?
Cost of equity refers to the return a company pays out to equity investors. The cost of equity allows the company to assess potential investments or projects. Potential investors use this figure as the minimum required return to ensure they are appropriately rewarded for the risk they undertake.
Cost of Equity Formula
You can calculate the cost of equity using two different models. The Capital Asset Pricing Model (CAPM) considers market-related risk and is usually used when calculating the Weighted Average Cost of Capital (WACC). The dividend capitalization model only applies to companies that pay out dividends and assumes constant dividend growth.
Let’s take a closer look at each of these methods.
Capital Asset Pricing Model (CAPM)
The Capital Asset Pricing Model (CAPM) can be used on any stock, including companies that don’t pay dividends. This model is more complex than the dividend capitalization model, and it considers both the level of risk relative to the market and the stock’s volatility.
The CAPM cost of equity formula is the following:
cost of equity = risk-free rate of return + β * (market rate of return - risk-free rate of return)
- risk-free rate of return: represents the expected return from a risk-free investment.
- β (beta): represents volatility or systematic risk of the asset. The higher the value, the higher the volatility.
- market rate of return: represents the average market return over a specified period of time (5-10 years).
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Dividend Capitalization Model
The dividend capitalization model is more straightforward than CAPM but can only be applied to companies that pay dividends. It assumes that dividends grow at a constant rate and it doesn’t account for investment risk in the way that CAPM does.
To calculate the cost of equity using the dividend capitalization model, use the following formula.
cost of equity = (next year’s dividends per share / current share price) + dividend growth rate
- next year’s dividends per share: this information is usually available from the company's financial reports or press releases, as dividends are announced well before distribution. However, if this information is not available directly, it can be estimated using historical data.
- current share price: the price of shares is listed under the company name or ticker on the relevant exchange.
- dividend growth rate: the growth rate for dividends can be calculated in different ways. The simplest way is to calculate growth for each year, then calculate the average. To calculate the growth rate, divide the dividends for year X by the dividends for the year X-1, then subtract one from the result.
Examples: How to Calculate Cost of Equity?
Below are examples of how to calculate the cost of equity using the methods described in the previous section: the Capital Asset Pricing Model (CAPM) and the dividend capitalization model.
Cost of Equity Using CAPM
Company Z is currently trading at a 9% rate of return, and the risk-free rate of return is 1%. Company Z’s beta value (0.9) is slightly lower than the market (1), making it slightly less volatile than average. You can calculate the cost of equity using the formula described in the previous section.
cost of equity = 1% + 0.9 * (9% - 1%) = 8.2%
Cost of Equity Using Dividend Capitalization Model
The current share price for Company A is $7, and they have announced dividends of $0.60 per share. Using historical data, analysts estimate a 2% dividend growth rate. You can use the formula from the previous section to calculate the cost of equity.
cost of equity = (0.60 / 7) + 2% = 8.5% + 2% = 10.5%
Why is the Cost of Equity Important?
The cost of equity is an important concept in stock valuation, and the value of the cost of equity is often used as the return threshold. Both companies and equity investors can use this metric to assess whether the return on a specific investment is appropriate given the level of risk.
The cost of equity is one of the components in the calculation of the Weighted Average Cost of Capital (WACC), together with the cost of debt. Depending on the company’s capital structure, it will rely on different proportions of equity and debt. The WACC formula considers the weighted cost of equity and of debt to provide the average cost of capital.
Cost of Debt is essentially the interest expense you pay on your business loans. Here’s how to calculate the Cost of Debt.
READ MOREWhat is the Difference Between Cost of Capital and Cost of Equity?
The cost of equity refers to the return that equity investors demand and is one of the components in the calculation of the cost of capital. The Weighted Average Cost of Capital (WACC) considers debt and equity financing, weighted according to the company’s capital structure.
What is the Difference Between Cost of Equity and Cost of Debt?
The cost of equity is usually higher than the cost of debt since investors take on more risk and are rewarded accordingly. However, while equity represents ownership, debt represents obligation, so debtholders are guaranteed payment. The cost of debt and the cost of equity are used to determine the cost of capital. The proportion of each varies by company, but it’s common for initial financing to be mostly in the form of debt.
Conclusion
The cost of equity is an important concept in stock valuation, and together with the cost of debt, it is used to calculate the Weighted Average Cost of Capital (WACC). While you have two methods available to calculate the cost of equity, the dividend capitalization model can only be applied to companies that pay out dividends.
You now know what the cost of equity is and why it is important for both the company and its equity investors. You also know how to calculate the cost of equity in two different ways: using the Capital Asset Pricing Model and using the dividend capitalization model. Finally, you have seen examples using both methods, so you’re ready to calculate the cost of equity to assess potential investments in other companies or projects within your own company.