Cost of Equity

What Is The Cost of Equity?

The cost of equity measures the return that shareholders expect from their investments. Companies use it as part of internal investment decisions. It is also used when deciding on external acquisition opportunities.

The models for calculating the cost of equity are the Dividend Capitalization and the Capital Asset Pricing Model (CAPM).

The cost of equity, when combined with the cost of debt as part of WACC, reflects the rate of return that companies are required to generate on their investments. Therefore, the WACC is compared with the expected return on investment.

If the WACC is higher than the expected return on investment, the investment might be a concern for stakeholders, as it suggests the investment is not generating returns above the company's cost of capital.

The dividend capitalization model is commonly used for companies that pay dividends, but it can be adapted for companies that do not pay dividends by using alternative financial metrics like free cash flows.

On the other hand, the CAPM formula can be applied to all publicly traded companies.

cost of equity formula

The cost of equity can be computed using two different methods. The first such method is the CAPM (Capital Asset Pricing Model), and the second is the Dividend Capitalization Model, which is especially relevant for companies that distribute dividends to their shareholders.

These methods provide useful insights into the company's financial health and assist investors in making informed decisions about their investments.

Let's understand both of the computation methods below:

Dividend Capitalization Model

The dividend capitalization model can only be used with publicly traded companies that issue dividends. It is much simpler when compared to the CAPM model as it relies on the formula for the cost of equity using the dividend capitalization model:

Re = (D₁ / P₀) + g

Where,

• Re: Cost of Equity
• D₁: Dividends Per Share for next year
• P₀: Current Market Value of Stock
• g: Growth Rate of Dividends

Let's understand the components:

1. Dividends Per Share (D₁)

The first is determining the expected dividend for the next year. Management should have a good estimate of the expected dividend for the upcoming year. The best way to estimate the expected dividend is to look at the past rates of dividends and their growth rate.

Another factor that can help estimate the expected dividend is the company's forecasted earnings.

2. Current Market Value of Stock (P₀)

The divisor in the formula is the stock's market value. This is simple and can be picked up from the stock market quotes.

3. Growth Rate of Dividends (g)

The final part of the equation is the growth rate of dividends. Just as we relied on historical data to calculate the expected dividend, we can use the same historical data to calculate the growth rate.

The growth rate for each year can be found by using the following equation:

Dividend Growth = (D_t / D_t-1) - 1

Where:

• D_t= Dividend payment of year t
• D_t-1= Dividend payment of year t - 1 (one year before year t)

Capital Asset Pricing Model (CAPM)

The Capital Asset Pricing Model (CAPM) is another method to determine the cost of equity for public companies.

Unlike the dividend capitalization formula, this model doesn't rely on dividends to determine the cost and can be used with companies that don't distribute dividends. However, this model is more reliant on assumptions than actuals and is more prone to manipulation. 

The formula for CAPM is given below:

E(R_i) = R_f + β_i * [E(R_m) – R_f]

Where:

• E(R_i): Expected Rate of Return
• R_f: Risk-Free Rate of Return
• β_i: Beta
• E(R_m): Expected Market Return

Here is a breakdown of each part:

1. Risk-Free Rate of Return (R_f)

The risk-free rate is the rate of return one can expect to generate on investment with zero risk. While no investment carries zero risk, most investors agree that US treasury bonds carry the least risk across all assets.

To find the risk-free rate, look up the yields on the treasury.  

2. Beta (β_i)

This measures how much a company's stock price is expected to rise or fall in response to market changes. It is calculated by comparing the company's stock return to that of the market as a whole over a certain period and then calculating the correlation coefficient.

Beta has different interpretations. If:

• βi = 1: It means that the stock's past performance is the same as that of the market, which gives it a low volatility rating
• βi > 1: It means its stock's price is more volatile than the market
• βi < 1: It means its stock's price is less volatile than the market

3. Expected Market Return E(R_m)

This is the expected return on an investment in the general stock market. The most commonly used standard of market returns is the S&P 500.

Cost of Equity Example (CAPM Approach)

Let's calculate the cost of equity using the CAPM approach.

Consider company Y is a technology company that is still breaking into the industry and has a beta of 1.25. The current market inflation rate is 4%. The US treasury bill rate is 1.5%. Finally, the S&P 500 is expected to keep pace with historical growth of 10%.

Now, let's check out the formula first:

E(R_i) = R_f + β_i * [E(R_m) – R_f]

Now, we can put up the values as per the formula. So,

• Rf = 1.5%
• βi = 1.25
• E(Rm) = 10

The risk-free rate can be determined by looking at the treasury rate, which is 1.5%. Now, we can plug them directly into the formula to find the cost of equity (K_e). 

Ke = 1.5% + 1.25 * (10 - 1.5%) = 12.125%

Therefore, the Cost of Equity (Ke) = 12.125%

Dividend Capitalization Model Example

Company X is a large nationwide retailer. Their most recent share price was $250, and they announced an annual dividend of $5. Last year, their annual dividend was $4.50, and the year before was $4.00.

This year, the company's earnings per share were $8, and it is expected that next year's earnings per share will be $10. 

To find the expected dividend for next year, we must find the dividend payout ratio from this year. The company earned $8 per share and paid out $5 in dividends. The payout ratio would be 8/5 or 0.625.

So, if next year's earnings per share are $10, we must multiply that amount by 0.625, which gives us $6.25 as the expected dividend payment for next year.  

To find the market value of the share price, we can look at the most recent share price. The most recent share price was $250. So, the current market value of a stock is $250.

Finally, finding the growth rate of dividends is based on historical dividend payments. For example, the increase in dividend payments during the previous two years was 12.5% and 11.1%, respectively. This means that the average dividend growth rate would be 11.8%.

Now, the formula is:

Re = (D₁ / P₀) + g

We'll see what values we've gotten:

• D₁ = 6.25
• P₀₌ 250
• g = 0.118

Putting the three values in the cost of equity formula, we get:

Cost of equity (Re) = (6.25 / 250) + 0.118

= 0.025 + 0.118

= 0.143 or 14.3%

Therefore, the cost of equity here is 14.3%.

Dividend Capitalization vs. CAPM

While both the dividend capitalization and capital asset pricing models are used to find the cost of equity, the equations are very different.

For starters, the dividend capitalization model can only be used by companies that offer dividends, while the capital asset pricing model can be used for any public company. 

The dividend capitalization model relies on historical data and assumptions about future dividend growth rates.

Similarly, CAPM involves assumptions but aims to evaluate the expected return of an asset considering its risk and market conditions. Both models have their own set of assumptions and complexities.

Let's understand this by taking a look at the table below:

What the Cost of Equity Tells You

The cost of equity has two distinct perspectives, depending on the involved party.

• For investors, it signifies the anticipated rate of return on an equity investment
• For companies, it establishes the required rate of return for a specific project or investment

In capital acquisition, companies face the choice between debt and equity. Although debt is more economical, it requires repayment.

On the other hand, equity, while not requiring repayment, generally incurs higher costs due to the tax advantages associated with interest payments. As the cost of equity exceeds that of debt, it typically offers a higher rate of return.

Understanding the cost of equity is important for companies seeking funds. A company with a low cost of equity can attract equity investments more effortlessly than one burdened with a high cost of equity.

Moreover, the cost of equity plays an important role in strategic decisions like acquisitions. When evaluating potential acquisitions, companies scrutinize the target company's equity cost to gauge the acceptability of associated risks.

Cost of Equity vs. Cost of Debt vs. Cost of Capital vs. WACC

Let us take a look at the differences below:

Free Resources

To continue learning and advancing your career, check out these additional helpful WSO resources:

• Beta Coefficient
• Capital Asset Pricing Model (CAPM)
• Discount Rate
• Return on Equity (ROE)
• WACC