What Is the Cost of Equity?
The cost of equity is the return that a company requires to decide if an investment meets capital return requirements. Firms often use it as a capital budgeting threshold for the required rate of return. A firm’s cost of equity represents the compensation that the market demands in exchange for owning the asset and bearing the risk of ownership. The traditional formula for the cost of equity is the dividend capitalization model and the capital asset pricing model (CAPM).
- Cost of equity is the return that a company requires for an investment or project, or the return that an individual requires for an equity investment.
- The formula used to calculate the cost of equity is either the dividend capitalization model or the CAPM.
- The downside of the dividend capitalization model—despite being simpler and easier to calculate—is that it requires that the company pays a dividend.
- The cost of capital, generally calculated using the weighted average cost of capital, includes both the cost of equity and the cost of debt.
- Companies often compare the cost of equity to the cost of debt when considering strategic maneuvers to raise additional capital from external sources.
Cost of Equity
Cost of Equity Formula
Using the dividend capitalization model, the cost of equity is:
Cost of Equity=CMVDPS+GRDwhere:DPS=Dividends per share, for next yearCMV=Current market value of stockGRD=Growth rate of dividends
What the Cost of Equity Can Tell You
The cost of equity refers to two separate concepts, depending on the party involved. If you are the investor, the cost of equity is the rate of return required on an investment in equity. If you are the company, the cost of equity determines the required rate of return on a particular project or investment.
There are two ways that a company can raise capital: debt or equity. Debt is cheaper, but the company must pay it back. Equity does not need to be repaid, but it generally costs more than debt capital due to the tax advantages of interest payments. Since the cost of equity is higher than debt, it generally provides a higher rate of return.
The dividend capitalization model can be used to calculate the cost of equity, but it requires that a company pays dividends. The calculation is based on future dividends. The theory behind the equation is that the company’s obligation to pay dividends is the cost of paying shareholders and therefore the cost of equity. This is a limited model in its interpretation of costs.
The capital asset pricing model, however, can be used on any stock, even if the company does not pay dividends. That said, the theory behind CAPM is more complicated. The theory suggests that the cost of equity is based on the stock’s volatility and level of risk compared to the general market.
The CAPM Formula is:
CoE=RFRR+B×(MRR−RFRR)where:CoE=Cost of EquityRFRR=Risk-free rate of returnB=BetaMRR=Market rate of return
In this equation, the risk-free rate is the rate of return paid on risk-free investments such as Treasuries. Beta is a measure of risk calculated as a regression on the company’s stock price. The higher the volatility, the higher the beta and relative risk compared to the general market.
The market rate of return is the average market rate. In general, a company with a high beta—that is, a company with a high degree of risk—will have a higher cost of equity.
The cost of equity can mean two different things, depending on who’s using it. Investors use it as a benchmark for an equity investment, while companies use it for projects or related investments.
Cost of Equity vs. Cost of Capital
The cost of capital is the total cost of raising capital, taking into account both the cost of equity and the cost of debt. A stable, well-performing company generally will have a lower cost of capital. To calculate the cost of capital, the cost of equity and the cost of debt must be weighted and then added together. The cost of capital is generally calculated using the weighted average cost of capital.
When considering the weighted average cost of capital, companies may favor the financial option that is least expensive. For example, its cost of equity may be 8% while its cost of debt may be 4%. Assuming a company has a balanced capital structure (50% of each), the company's total cost of capital is 6%.
As a company goes out to seek additional capital, it often compares which method is cheaper than its weighted average cost of capital. In this case, the company's average debt costs less, so the company may be opposed to issuing additional equity at a higher cost.
What Is the Cost of Equity?
The cost of equity is the return that a company must realize in exchange for a given investment or project. When a company decides whether it takes on new financing, for instance, the cost of equity determines the return that the company must achieve to warrant the new initiative. Companies typically undergo two ways to raise funds: through debt or equity. Each has differing costs and rates of return.
How Do You Calculate the Cost of Equity?
There are two primary ways to calculate the cost of equity. The dividend capitalization model takes dividends per share (DPS) for the next year divided by the current market value (CMV) of the stock, and adds this number to the growth rate of dividends (GRD), where Cost of Equity = DPS ÷ CMV + GRD. Conversely, the capital asset pricing model (CAPM) evaluates if an investment is fairly valued, given its risk and time value of money in relation to its anticipated return. Under this model, Cost of Equity = Risk-Free Rate of Return + Beta × (Market Rate of Return – Risk-Free Rate of Return).
What Is an Example of Cost of Equity?
Consider company A trades on the S&P 500 at a 10% rate of return. Meanwhile, it has a beta of 1.1, expressing marginally more volatility than the market. Presently, the T-bill (risk-free rate) is 1%. Using the capital asset pricing model (CAPM) to determine its cost of equity financing, you would apply Cost of Equity = Risk-Free Rate of Return + Beta × (Market Rate of Return – Risk-Free Rate of Return) to reach 1 + 1.1 × (10-1) = 10.9%.
What Is the Weighted Average Cost of Equity?
A company's weighted average cost of equity measures the cost of equity proportionally across the types of equity. Instead of taking the simple average cost across all types of equity (i.e. common shares, preferred shares, etc.), the weighted average cost of equity proportionally considers the equity value of each type of equity. To calculate the weighted average cost of equity, multiple by the cost of any given specific equity type by the percentage of capital structure it represents.
The Bottom Line
A company's cost of equity is an important consideration as companies determine the best way to raise capital. Often calculated as the dividends issued per share divided by the current market price (plus a growth rate), the cost of equity is the expense a company should assume it must return back to investors based on prevailing costs. The cost of equity is often compared to the cost of debt when making capital structure decisions.