What is Cost of Equity?
The cost of equity is the required rate of return an investor expects on their equity investments to compensate for the risk profile of the asset. If a company is considering investing in a project, the cost of equity is the required rate of return on the investment in that project. The calculation for both is the same. Cost of equity is a key part of a company’s capital structure and is an element in the WACC calculation which has uses in the discounted cash flow analysis.
Capital structure is a term that describes how a company is financed. This is ordinarily a mix of debt, such as debentures, loans and corporate bonds, and equity financing.
To find out the cost of equity for a company, you need to use one of two calculations: the dividend capitalization model or the capital asset pricing model (CAPM formula).
Key Learning Points
- Cost of equity is the required rate of return an investor expects on their equity investments to compensate for the risk profile of the asset
- WACC is the weighted average cost of capital and is a market based calculation
- The capital asset pricing model is frequently used to calculate the cost of equity and states that the return on a security is calculated as some level of systematic risk plus a risk premium depending on the industry the company operates in
- Cost of equity is a component of WACC which is used in a discounted cash flow analysis to calculate an intrinsic value of a company
How to Calculate Cost of Equity
Capital Asset Pricing Model
The CAPM formula is useful for any stock, as it does not require the company to be paying dividends. It looks quite complicated below, but we’ll walk through each step, and show it with some simple numbers at the end. The formula is shown below:
ERi= Rf + βi (ERm – Rf)
ERi = expectated return of investment
Rf = risk-free rate
βi = beta of the investment
(ERm – Rf) = market risk premium
The risk-free rate represents the expected rate of return for investment in a “risk free” security. In reality, there is no such thing as a risk-free security and the rate is most frequently benchmarked against a 10-year government bond. The risk of an economically developed government defaulting on its interest payments is considered “risk free”.
Beta is a measure of the systematic risk of an investment. It measures the covariance between the rate of return of a company’s stock and the overall market return. If the beta is higher than 1, it will increase the risk of the investor’s portfolio. If it is lower than 1, it will decrease the risk in the portfolio.
The beta is then multiplied by the market risk premium, which is the return that is expected in the market above the risk-free rate. ERm relates to expected return in the market, and Rf is the risk-free rate, the same as earlier in the calculation.
An investor is planning to invest in a stock worth $50 per share today that pays a 4% annual dividend. The stock has a beta when compared to the market of 1.5, meaning it is riskier than the market portfolio (which has a beta of 1). The return on a 10-year US government bond is 3%, and the investor anticipates the market to increase in value by 10% per year. Using this information, we get:
Remember, our ERi is the same as the cost of equity in the WACC equation, so our cost of equity is 12.8%.
Dividend Capitalization Model
The dividend capitalization model approximates a future dividend stream based on the company’s dividend history and uses an assumed growth rate and the current market value of the stock to arrive at the cost of equity. It is simpler than the CAPM formula but has limitations.
In order to use the dividend capitalization model, the company has to be paying dividends, otherwise, the formula will not work.
How is Cost of Equity used in the WACC?
Cost of equity, along with cost of debt represents the total return required by the providers of capital to compensate for the risk. When the cost of equity is multiplied by the proportion of equity in a company’s capital structure, and the cost of debt is similarly multiplied by the proportion of debt, you reach the Weighted Average Cost of Capital, or WACC.
When you’re looking at the WACC, it’s helpful to remember that the cost of debt is usually lower than the cost of equity. The cost of equity is the return that investors expect on their investment. If the cost of debt is higher, it could indicate that the company is in a poor credit position as it has had to agree to high interest on its debts in order to secure financing.