What is '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 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 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 determines the required rate of return on a particular project or investment.
Cost of Equity
There are two ways a company can raise capital: debt or equity. Debt is cheap, but the company must pay it back. Equity does not need repaid, 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.
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 percent over the past 80 years. In general, a company with a high beta, that is, a company with a high degree of risk, will pay more for equity.

Capital Asset Pricing Model  CAPM
Capital Asset Pricing Model is a model that describes the relationship ... 
Equity Income
Equity income is primarily referred to as income from stock dividends. ... 
Equity Fund
An equity fund is a type of fund that uses investors' capital ... 
Return on Equity (ROE)
Return on equity measures a corporation's profitability by revealing ... 
Market Value Of Equity
Market value of equity is the total dollar value of a company's ... 
Flotation Cost
Flotation costs are incurred by a publicly traded company when ...

Investing
The Capital Asset Pricing Model: an Overview
CAPM helps you determine what return you deserve for putting your money at risk. 
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. 
Small Business
Explaining Cost Of Capital
Cost of capital is the cost of funds used to finance a business. 
Investing
How AQR Places Bets Against Beta
Learn how the bet against beta strategy is used by a large hedge fund to profit from a pricing anomaly in the stock market caused by high stock prices. 
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. 
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. 
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? 
Investing
Digging Into the Dividend Discount Model
The DDM is one of the most foundational financial theories, but it's only as good as its assumptions. Learn if this model works for you and how to use it.

How does market risk affect the cost of capital?
Find out how market risk directly affects the total cost of capital, including how to use the capital asset pricing model ... Read Answer >> 
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 >> 
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 >> 
Why would a company use a form of longterm debt to capitalize operations versus ...
Learn about the different consequences of using longterm debt versus equity to raise capital for business activity, and ... Read Answer >> 
How do you calculate costs of capital when budgeting new projects?
Before budgeting for a new project, a company must assess the overall level of project risk relative to their normal business ... 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 >>