Who pays for the CoE - specifically stock price appreciation?
Hi all,
Conceptual question on the CoE that I'm trying to wrap my head around.
From the perspective of a company, the CoE represents the cost of funding paid out to equity holders. Using the CAPM model, and assuming Beta is 1, this would be the market return. Hence, the CoE for a company in our example is the market return. Who pays for this cost? Obviously, dividends would be paid out by the company. But what about the other major component of an equity holders returns - namely stock price appreciation? Is this paid out by the company or the market? If it's the market, why is it considered a component of CoE to the firm?
Thanks!
Cost of equity is the return that investors - actually or theoretically - require if they're going to invest in a company's equity. Take a PE multiple, and think of it like you would the coupon on a bond, i.e. express it as a percentage. Forget dividends for now, but imagine a company with $1.00 a share of earnings, and a stock price of $20.00. The PE is 20, and the cost of equity is 5% ($1.00 / $20.00). If investors will only pay you $10.00 a share for that buck of earnings, your PE is 10 and your CoE is 10%.
This has gotten harder to grasp in the past ~50 years because public companies aren't just gigantic, steady-eddy cashflow maximizers anymore, and most equity investors aren't interested in dividends (unless of course the company can't put the money to work productively). But CoE is the multiple of shareholder return that the share price represents, inverted and expressed as a percentage.
This is simplifying it a little and excludes the earnings growth rate from the calc, but you can look all that up...
The company’s existing shareholders (i.e. the “company” itself) pays the CoE in the form of the value of their equity. If you invest in a company, and then the company’s CoE of equity goes up but it’s expected cash flows remain the same, the value of your equity will fall. It’s actually analogous to the cost of debt. A simple example - imagine two companies that generate identical cash flows (A and B).
If Company A has a higher cost of debt (i.e pays a higher interest rate), and they both raise the same amount of debt, Company A has less remaining cash flows left over for shareholders than Company B. Similarly, if Company A's CoE is higher, in order to raise the same amount of cash through an equity issuance, Company A will have to sell a larger share of its total equity (since A’s investors demand a higher return), so Company A's existing shareholders are diluted more than Company B's shareholders. Since the cash flows are both for both companies, Company A’s existing shareholders have a claim on less cash. And the value of an investment = all future cash flows the investor is entitled to.
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