What is the cost of equity?

The cost of equity is a central variable in financial decision-making for businesses and investors. Knowing the cost of equity will help you in the effort to raise capital for your business by understanding the typical return that the market demands on a similar investment. Additionally, the cost of equity represents the required rate of return on a project or capital investment to generate profit.

From an investing perspective, the cost of equity measures the rate of return paid out to equity investors, which is influenced by the risk of the investment. This article explores how to calculate and use the cost of equity in making business and investment decisions.

How the cost of equity is used

The cost of equity is part of a company's overall cost of capital and is an input to stock valuation models. Business leaders and investors can make better-informed decisions by using the cost of equity to contextualize risk and return on investment.

The cost of capital and capital structure

Capital structure refers to the sources of capital for a business. Most mature companies have a capital structure that combines equity and debt financing. For these businesses, the weighted average cost of capital, WACC, is used in evaluating investments.

The weighted average cost of capital considers the cost of each type of financing and the proportion of funds generated by each type. For businesses without debt, the cost of capital equals the cost of equity.

The cost of capital measures business effectiveness

The cost of capital is an essential indicator of how effectively the business is run and is inversely related to company valuation. Higher capital cost means higher risk and depresses a company's valuation.

The cost of capital helps determine the hurdle rate for business initiatives

The hurdle rate, also known as the discount rate, is a number that company managers use when deciding to greenlight products and services. The hurdle rate is the minimum rate of return on a project that will be profitable for the company and its investors.

Some factors that managers consider when setting the hurdle rate include the opportunity cost of not pursuing other investments, the risks undertaken in the specific project, and the company's weighted average cost of capital.¹

Comparing the cost of debt and equity financing

Because interest on debt is tax-deductible, it can cost less than equity financing. Also, debt holders have legal priority over equity holders, making their investments less risky. Equity investors expect a higher return because they bear a higher investment risk. You can learn more about different strategies for raising capital here.

Balancing capital structure is an important management function

Startup companies usually rely on equity investment until they can build up enough cash flow and assets to collateralize debt financing. When they can add debt to their capital structure, these companies will see their cost of equity and WACC go down.

However, the cost advantage of debt financing erodes if the company becomes over leveraged. Because debt payments are contractually guaranteed, when a company carries too much debt relative to its cash flow, the default risk for its underwriters goes up, along with interest rates on new debt, and the company valuation goes down.

Striking the right balance between debt and equity can make the difference between success and failure, making it a top concern for company leadership.

How is the cost of equity calculated?

There are two commonly used models for calculating the cost of equity: the CAPM or capital asset pricing model and the dividend capitalization model. Both models can provide insight into the expected return on an equity investment but are only estimations. The CAPM is the most widely used formula. It is also a more accurate calculation than the dividend capitalization model because it includes consideration of investment risk.

The dividend capitalization model for calculating the cost of equity

The dividend capitalization model for estimating current market value rests on a historical analysis of dividends paid by a company to estimate future earnings. Using the following equation, you can estimate a fair price for a company's shares.

Cost of equity = (Annualized dividends per share / Current stock price) + Dividend growth rate

There are two ways to obtain the dividend growth rate

You can obtain a value for the dividend growth rate by taking an average growth rate for previous years or through the Compound Average Growth Rate (CAGR) formula.³

The formula for calculating one year's dividend growth rate is:

Dividend growth=(Current year's dividends per share/Previous year's dividends per share) -1

The formula for calculating CAGR is:

Dividend growth=(D_n/D₀)1/n-1
Where:

• D₀=the first dividend/share value
• D_n=the most recent dividend/share value
• n=the number of years in which dividends have been paid

The dividend capitalization model assumes that dividend payments will continue increasing, which isn't necessarily true. The model also doesn't account for risk or the possible appreciation of the stock's value when calculating a fair share price.

If the company is closely held and doesn't pay dividends, you can estimate based on its average net income and cash flow compared with a similar company that does pay dividends. A better method is to use the CAPM for the cost of equity calculation.

The capital asset pricing model for calculating the cost of equity

The capital asset pricing model was developed in the early 1960s by an economist studying how risk influences investment returns. The CAPM cost of equity calculation can be used on any type of asset. It recognizes that investors demand compensation for the time value of money and the investment risk.

The CAPM model recognizes two types of investment risk: systematic risk and unsystematic risk. Systematic risk is also called market risk, the generalized risk of investing. Geopolitical and environmental events contribute to systemic risk. Specific, or unsystematic, risk depends on the investment.

The CAPM evaluates investments in the context of the overall market

The CAPM helps you understand the return an investor requires by comparing the investment's risk (often characterized as its volatility) and potential return to a risk-free rate of return.

The first part of solving the equation is to set a couple of standards, one for volatility and one for a risk-free rate of return. The Standard & Poor's 500 Index is often used as the volatility standard, with U.S. Treasury securities as the standard for the risk-free return rate.

The risk-free rate in this equity formula addresses the time value of money, one component for which capital providers want to be compensated. Depending on the type of investment, 3-month T-bills or longer-term government bonds are used.

The formula derives a market risk premium by subtracting the risk-free rate of return from the expected market return for a standardized portfolio. The S&P 500 is typically used for the standardized portfolio, as well as for the volatility standard.

Then the market risk premium is multiplied by the risk or volatility of the specific investment to generate an equity risk premium.

Finally, the equity risk premium is added to the risk-free rate to get the cost of equity or expected return for a specific investment. In the case of a company's stock, this would be a stock price on which you would anchor a purchase decision.

Accounting for specific risks in the CAPM equation

The Greek letter beta represents the volatility of the investment in a particular company, and the higher a company's risk, the higher the firm's cost of equity. If you're evaluating an investment in a private company, you can estimate its beta based on the average beta for a set of similar companies traded on a public market.

Volatility is usually expressed in relation to the S&P 500, which is assigned the value of one. A higher beta means a riskier investment, and a value above one means the risk undertaken with the investment is higher than average. Conversely, a beta of less than one indicates the stock is more stable than the overall market.

The CAPM formula for the cost of equity

Calculate the cost of equity using the CAPM formula as follows:

Expected return=R_f+β(R_m-R_f)
Where:

• R_f=the risk-free rate of return
• R_m=the expected market return rate
• β=beta

What the CAPM doesn't consider

The capital asset pricing model does not account for any dividend payment that the investment offers.

Choosing reference standards to calculate cost of equity

Why are the S&P 500 and government securities used in the CAPM equity calculation? Size and liquidity are two reasons.

The S&P 500 index tracks the largest companies across industries, offering a good snapshot of the overall health of the general market and the American economy. The index's breadth and the fact that its composition is updated quarterly ensure that it is a good snapshot. The market capitalization of the S&P 500 represents most of the value in the entire U.S. stock market. As of this writing, the S&P 500 market capitalization is $34.238 trillion, while the capitalization of the whole market is $40.719 trillion.^{4, 5}

Treasury securities also represent a large, stable and liquid market. SIFMA, a trade association representing broker-dealers, investment banks and asset managers operating in the U.S. and globally, showed that there was $23.7 trillion in outstanding U.S. Treasury securities as of October 2022, with $622 billion being actively traded.⁶ Because the U.S. government is unlikely to ever default on its obligations and there is a robust trading market for the securities, this makes treasury rates a good approximation for risk-free rates of return.

However, you should not always assume that the S&P 500 is the best market reference to use when calculating your cost of equity. The S&P includes only large-cap U.S. companies, which is not a good benchmark for small-cap stocks, foreign stocks and other investment vehicles. So paying careful attention to the choice of a market benchmark will help assure a more accurate calculation of the required rate of return on equity when using the capital asset pricing model.

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