What is the cost of equity and what is it for?

The cost of equity is the profitability that a company requires to decide whether an investment meets the return on capital requirements. The cost of equity refers to two different concepts, depending on the party in question. Let's look at what cost of equity is and how to use it.

What is the cost of equity

The cost of equity is the profitability that a company requires to decide whether an investment meets the return on capital requirements. Companies often use it as a capital budgeting threshold for the required rate of return. A company's cost of equity represents the compensation that the market demands in exchange for owning the asset and bearing the risk of ownership. Traditional cost of equity formulas are the dividend capitalization model and the capital asset pricing model (CAPM).

What is the cost of equity for?

The cost of equity refers to two different concepts, depending on the party in question. 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 rate of return required for a specific project or investment. A company can obtain capital in two ways: through debt or through equity. Debt is cheaper, but the company must pay it back. Equity does not have to be repaid, but typically costs more than debt capital due to the tax advantages of paying interest. Since the cost of equity is higher than that of debt, they typically provide a higher rate of return.

Cost of Equity Formula

There are two main ways to calculate the cost of equity:

  • The dividend capitalization model takes the dividends per share (DPS) for the next year divided by the current market value (CMV) of the stock, and adds this number to the dividend growth rate (GRD), where Cost equity = DPS ÷ CMV + GRD.
  • The capital asset pricing model (CAPM) assesses whether an investment is fairly valued, given its risk and the time value of money relative to its expected return. According to this model, Cost of Equity = Risk-Free Rate of Return + Beta × (Market Rate of Return – Risk-Free Rate of Return).
formulas

Formula to calculate the cost of equity.

Cost of Equity Calculation Example

Let's give an example to understand it better. Let's imagine that company A is listed on the S&P 500 with a profitability rate of 10%. This has a beta of 1,1, which expresses more volatility than the market. Currently, the T-bill (risk-free rate) is 1%. Using the capital asset pricing model (CAPM) to determine your cost of financing through equity, we would apply:

Cost of equity = Risk-free rate of return + Beta × (Market rate of return – Risk-free rate of return) to arrive at 1 + 1,1 × (10-1) = 10,9%.


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