What Is the Cost of Equity?

What Is the Cost of Equity?

Let me explain the cost of equity directly: it's the return a company requires to determine if an investment meets its capital return needs. You see, firms use this as a threshold for the required rate of return in capital budgeting. The standard ways to calculate it are the dividend capitalization model and the capital asset pricing model (CAPM).

Key Takeaways

Understand that the cost of equity is the return a company demands for an investment or project, or what an individual expects from an equity stake. You calculate it using either the dividend capitalization model or CAPM. One limitation of the dividend model, even though it's simpler, is that it only works if the company pays dividends. Remember, the overall cost of capital, via the weighted average, includes both equity and debt costs. Companies often weigh equity costs against debt when planning to raise capital externally.

How the Cost of Equity Works

The cost of equity means different things depending on your perspective. If you're an investor, it's the rate of return you need on an equity investment. If you're the company, it's the required return on a specific project or investment.

Companies raise capital through debt or equity. Debt is cheaper but must be repaid, while equity doesn't need repayment but usually costs more because of tax benefits on debt interest. Since equity is pricier, it typically offers a higher return.

Cost of Equity Formula

Using the dividend capitalization model, the cost of equity is DPS divided by CMV, plus GRD—where DPS is next year's dividends per share, CMV is the current market value of the stock, and GRD is the dividend growth rate.

Special Considerations

You can use the dividend model for cost of equity, but only if the company pays dividends. This calculation relies on future dividends, viewing the obligation to pay them as the cost to shareholders, hence the equity cost. It's limited in scope, though.

The CAPM works for any stock, even non-dividend payers, but its theory is more complex. It bases the cost on the stock's volatility and risk relative to the market.

CAPM Formula

The CAPM formula is CoE equals RFRR plus B times (MRR minus RFRR), where CoE is cost of equity, RFRR is the risk-free rate of return, B is beta, and MRR is the market rate of return.

Here, the risk-free rate comes from investments like Treasuries. Beta measures risk via regression on stock price; higher volatility means higher beta and risk. The market rate is the average return, so a high-beta company has a higher cost of equity.

Cost of Equity vs. Cost of Capital

The cost of capital is the full cost of raising funds, factoring in both equity and debt.

A stable company usually has a lower cost of capital. You calculate it by weighting equity and debt costs, then adding them—typically using the weighted average cost of capital.

When seeking more capital, companies compare options to their weighted average. For instance, if equity costs 8% and debt 4% in a balanced structure, total cost is 6%. Debt being cheaper might make companies avoid issuing more equity.

How Will I Use This in Real Life?

You can apply the cost of equity as an investor to check if a stock or private investment offers enough return for the risk—if below the cost, it might not be worthwhile.

For businesses, it helps evaluate if new projects justify equity funding or if debt is better, guiding project choices.

What Is the Cost of Equity?

To reiterate, it's the return a company must achieve for an investment or project. When deciding on new financing, this determines the needed return. Funds come via debt or equity, each with its costs and returns.

How Do You Calculate the Cost of Equity?

There are two main methods. The dividend model is DPS over CMV plus GRD. The CAPM checks if an investment is fairly valued by risk and time value: CoE equals risk-free rate plus beta times (market rate minus risk-free rate).

What Is an Example of Cost of Equity?

Take company A on the S&P 500 with a 10% return, beta of 1.1, and 1% T-bill rate. Using CAPM: 1 + 1.1 times (10-1) equals 10.9%.

What Is the Weighted Average Cost of Equity?

It's the proportional cost across equity types, like common and preferred shares, by multiplying each cost by its capital structure percentage.

The Bottom Line

The cost of equity is crucial for deciding how to raise capital. You calculate it as dividends per share over current price plus growth, or via CAPM. It's the return owed to investors based on costs, often compared to debt for capital decisions.