What Is the Cost of Equity?
The cost of equity is the return that a company must achieve to determine if an investment meets capital return requirements. It serves as a vital capital budgeting threshold for the required rate of return. In essence, it represents the compensation that the market demands for owning an asset and bearing the risk of ownership. Two primary methods to calculate this are the Dividend Capitalization Model and the Capital Asset Pricing Model (CAPM).
Key Takeaways
- The cost of equity is the return a company requires for an investment or project or the return an individual seeks for an equity investment.
- It is calculated using either the Dividend Capitalization Model or the CAPM.
- While simpler, the dividend capitalization model requires the company to pay dividends.
- The cost of equity incorporates both equity and debt costs when calculating the overall cost of capital.
- Frequently, companies compare the cost of equity to the cost of debt in their strategic maneuvers to raise additional capital from external sources.
Cost of Equity Formula Using the Dividend Capitalization Model
Cost of Equity = (DPS / CMV) + GRD
where:
DPS = Dividends per share, projected for next year
CMV = Current market value of the stock
GRD = Growth rate of dividends
What the Cost of Equity Can Tell You
The cost of equity has different meanings for investors and companies. For investors, it represents the required rate of return on an equity investment. For companies, it’s the rate of return necessary for a project or investment.
Companies use either debt or equity to raise capital. Although debt is cheaper, it must be repaid. Equity doesn’t have to be repaid but usually costs more due to the lack of tax advantages compared to interest payments on debt. Therefore, equity generally provides a higher rate of return.
Special Considerations
The dividend capitalization model is limited as it requires companies to pay dividends and bases calculations on future dividends. Meanwhile, CAPM can apply to any stock but is more complex, factoring in the stock’s volatility and level of risk.
CAPM Formula
Cost of Equity = Risk-Free Rate of Return + Beta * (Market Rate of Return - Risk-Free Rate of Return)
where:
Risk-Free Rate of Return = the return on risk-free investments such as Treasuries
Beta = a measure of the stock's risk relative to the market
Market Rate of Return = the average market return
A higher beta indicates greater volatility and relative risk, resulting in a higher cost of equity.
Cost of Equity vs. Cost of Capital
The cost of capital encompasses the total cost of raising capital, combining both equity and debt costs. A company’s well-being typically correlates with a lower cost of capital, calculated using the Weighted Average Cost of Capital (WACC). Comparing the cheaper financial option determines whether raising additional debt or equity capital is more beneficial.
Example of Cost of Equity
Consider Company A listed in the S&P 500 with a return rate of 10%. The company has a beta of 1.1, indicating more volatility than the market, while risk-free T-bills yield 1%. Using CAPM, calculate the cost of equity:
Cost of Equity = 1% + 1.1 * (10% - 1%) = 10.9%
Weighted Average Cost of Equity
The weighted average cost of equity considers the equity value across different types, such as common and preferred shares. To calculate:
Weighted Average Cost of Equity = (Cost of Specific Equity Type) * (Percentage of Capital Structure)
The Bottom Line
Understanding a company’s cost of equity is critical in making informed capital raising decisions. Whether calculated via dividends per share or market risk models, the cost of equity should align with prevailing market conditions and be compared with the cost of debt to determine the optimal financing strategy.
Related Terms: Cost of Debt, Weighted Average Cost of Capital (WACC), Rate of Return, Debt Financing, Equity Investment.
