Loading the player...

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.

Cost Of Equity

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 = 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 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.

RELATED TERMS
  1. Capital Asset Pricing Model - CAPM

    Capital Asset Pricing Model is a model that describes the relationship ...
  2. Equity

    Equity is the value of an asset less the value of all liabilities ...
  3. 100% Equities Strategy

    A 100% equities strategy is an investment strategy for an individual ...
  4. Required Rate Of Return - RRR

    The required rate of return is the minimum return an investor ...
  5. Optimal Capital Structure

    An optimal capital structure is the mix of debt, preferred stock and common ...
  6. Capital Structure

    Capital structure is how a firm funds its operations and growth, ...
Related Articles
  1. Investing

    How to calculate required rate of return

    The required rate of return is used by investors and corporate-finance professionals to evaluate investments. In this article, we explore the various ways it can be calculated and put to use.
  2. Investing

    The Equity-Risk 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.
  3. Investing

    Microsoft Is Paying Dividends. Is Its Share Price Undervalued Or Overvalued Based On DDM? (MSFT)

    How can you use the dividend discount model to estimate the value the common stock of Microsoft?
  4. Investing

    Equity Multiplier

    The equity multiplier is a straightforward ratio used to measure a company’s financial leverage. The ratio is calculated by dividing total assets by total equity.
  5. Investing

    How Risk Free Is the Risk-Free Rate of Return?

    This rate is rarely questioned—unless the economy falls into disarray.
  6. Investing

    Beta: Know the Risk

    Beta says something about measuring price risk in stocks, but how much does it say about fundamental risk factors too?
  7. Financial Advisor

    Should My Portfolio Include Private Equity?

    Private equity offers a lot of potential, but is it worth the risk?
  8. Investing

    Reduce Your Risk With ICAPM

    Avoid unnecesary risks involved in CAPM calculations by also incorporating ICAPM into the mix.
RELATED FAQS
  1. How do I use the CAPM (capital asset pricing model) to determine cost of equity?

    Learn about the elements of the capital asset pricing model, and discover how to calculate a business' cost of equity financing ... Read Answer >>
  2. 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 >>
  3. How do you calculate a company's equity?

    Company equity, or shareholders' equity, is the net difference between a company's total assets and total liabilities. Read Answer >>
  4. What is the difference between the cost of capital and the discount rate?

    Learn about the differences between the cost of capital and the discount rate as they relate to estimating a required return ... Read Answer >>
  5. How do interest rates influence a corporation's capital structure?

    Learn about how changing interest rates can affect a corporation's capital structure because of their impact on the cost ... Read Answer >>
Trading Center