Can someone tell me the reason behind this answer?
Company A has P/E of 10x. Company B has P/E of 20x. Which company has the higher cost of equity?
The answer is company A but I can't seem to reason out why so.
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This has been covered extensively already. Use the search function.
With that said, the basic idea is:
P/E= how much an investor is willing to pay for $1 of earnings.
A P/E of 20 vs 10 means investors are willing to pay $20 (double) for every $1 of earnings, thus a lower cost/easier funds to the issuer
See, I'm not so crazy when I tell these schmucks to use the search bat
How does growth get taken into account?
Growth is implied in the valuation of the company, in that higher growth companies typically command higher multiples. Another way of conceptualizing it is taking the inverse of the P/E ratio and assume that to be your cost of equity.
But cost of equity is generally calculated with a CAPM? I wouldn´t had an answer either on this.
The P/E ratio is the share price of the company/earnings per share. The alternate formula for calculating the cost of equity for a firm is: Cost of equity = (Dividends per share/Share price) * Growth rate of dividends. The higher the share price of a company, the higher the company's P/E ratio. Subsequently, the higher share price also means a lower cost of equity (using the alternate formula). Therefore on the flip side, the lower a company's share price, the lower its P/E ratio, but the higher its cost of equity.
The company with a P/E of 10x should have a share price that is smaller than the company that has a P/E of 20x, which would imply that its cost of equity is higher. However, this logic assumes that the other variables in the equation are similar for both firms.
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