What Is the Cost of Equity?
The cost of equity is the return 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 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
Cost of Equity Formula
Using the dividend capitalization model, the cost of equity is:
Understanding the 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 determines the required rate of return on a particular project or investment.
There are two ways 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.
- Cost of equity is the return a company requires for an investment or project, or the return an individual requires for an equity investment.
- The formula used to calculate the cost of equity is either the dividend capitalization model or the capital asset pricing model.
- The downfall of the dividend capitalization model, although it is simpler and easier to calculate, is that it requires 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 cost of debt.
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 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 = Risk-Free Rate of Return + Beta * (Market Rate of Return - Risk-Free 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, which has generally been assumed to be roughly 10% over the past 80 years. 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, will generally have a lower cost of capital. To calculate the cost of capital, the cost of equity and cost of debt must be weighted and then added together. The cost of capital is generally calculated using the weighted average cost of capital.