What is 'Cost Of Equity'
The cost of equity is the return a company requires to decide if an investment meets capital return requirements. It is often used as a capital budgeting threshold for required rate of return. A firm's cost of equity represents the compensation the market demands in exchange for owning the asset and bearing the risk of ownership. The traditional formulas for cost of equity (COE) are the dividend capitalization model and the capital asset pricing model.
BREAKING DOWN 'Cost Of Equity'
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 is used to determine the required rate of return on a particular project or investment.
Cost of Equity
There are two ways in which a company can raise capital: debt or equity. Debt is cheap, but it must be paid back. Equity does not need to be paid back, but it generally costs more than debt due to the tax advantages of interest payments. Even though the cost of equity is higher than debt, equity generally provides a higher rate of return than debt. Analysts calculate the cost of equity with the dividend growth model and the capital asset pricing model (CAPM).
Cost of Equity Models and Theory
The dividend growth model is 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 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 the cost of equity is based on the stock's volatility and level of risk compared to the general market.
The CAPM formula is: Cost of Equity = RiskFree Rate of Return + Beta * (Market Rate of Return  RiskFree Rate of Return).
In this equation, the riskfree rate is the rate of return paid on riskfree 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, which has generally been assumed to be 11 to 12% over the past 80 years. In general, a company with a high beta, that is, a company with a high degree of risk, is going to pay more to obtain equity.

Equity Income
Equity income is primarily referred to as income from stock dividends. ... 
Required Rate Of Return  RRR
The required rate of return is the minimum return an investor ... 
Incremental Cost of Capital
Incremental cost of capital is a capital budgeting term that ... 
Return on Equity (ROE)
Return on equity refers to the profitability returned in direct ... 
Flotation Cost
Flotation costs are incurred by a publicly traded company when ... 
Equity Market Capitalization
Equity market capitalization is the measure of the total market ...

Investing
Is Apple's Stock Over Valued Or Undervalued?
Despite several drawbacks, the CAPM gives an overview of the level of return that investors should expect for bearing only systematic risk. Applying Apple, we get annual expected return of about ... 
Investing
The EquityRisk Premium: More Risk For Higher Returns
Learn how the expected extra return on stocks is measured and why academic studies usually estimate a low premium. 
Investing
Investors Need A Good WACC
Weighted average cost of capital may be hard to calculate, but it's a solid way to measure investment quality. 
Investing
Target Corp: WACC Analysis (TGT)
Learn about the importance of capital structure when making investment decisions, and how Target's capital structure compares against the rest of the industry. 
Financial Advisor
Should My Portfolio Include Private Equity?
Private equity offers a lot of potential, but is it worth the risk? 
Investing
How Investment Risk Is Quantified
FInancial advisors and wealth management firms use a variety of tools based in modern portfolio theory to quantify investment risk. 
Investing
Reduce Your Risk With ICAPM
Avoid unnecesary risks involved in CAPM calculations by also incorporating ICAPM into the mix. 
Investing
Verizon Stock: Capital Structure Analysis (VZ)
Investigate Verizon's capital structure, and understand how debt and equity capitalization and enterprise value interact with each other. 
Investing
How To Calculate Beta Of A Private Company
We explain two methods for calculating the beta of a private company.

How do I calculate the cost of equity using Excel?
Learn how to calculate the cost of equity in Microsoft Excel using the capital asset pricing model, or CAPM, including brief ... Read Answer >> 
How does a company choose between debt and equity in its capital structure?
Learn about the benefits and drawbacks of debt and equity financing. Find out how to compare capital structures using cost ... Read Answer >> 
Cost of Capital vs Required Return
Though they may sound similar, they do have key conceptual differences. Take a look at the primary differences between an ... Read Answer >> 
determine the proper weights of costs of capital?
Learn how to calculate the weights of the different costs of capital, as well as how this is used to determine the weighted ... Read Answer >> 
Use market risk premium for expected market return
Find out how the expected market return rate is determined when calculating market risk premium – and how to estimate investment ... Read Answer >> 
How do you calculate costs of capital when budgeting new projects?
Discover how a company should estimate its costs of capital when budgeting for a new business project using the weighted ... Read Answer >>