What Cost of Equity Is and How to Calculate It (2024)

In corporate finance, cost of equity represents the return a company must generate to satisfy its shareholders. Financial advisors also rely on the cost of equity when evaluating investment opportunities and making recommendations to clients. It helps them assess a company’s financial health, growth prospects and potential returns, which is essential for constructing diversified portfolios that balance risk and reward.

Understanding Cost of Equity

Cost of equity represents the minimum rate of return that a company must earn on the equity-financed portion of its investments to maintain the current market value of its shares. In other words, cost of equity is the return that the market requires to justifyinvesting in a particular company or asset.

For example, if a company’s cost of equity is 10%, it means that the company must generate a return of at least 10% on its equity-financed investments to meet shareholder expectations.

Cost of equity plays an important role in a company’s financial decision-making, particularly in relation to capital budgeting and investment decisions. So, if a firm is considering a new project, it will compare the expected return of the project to its cost of equity to determine whether the project is financially viable. Then, if the expected return is higher than the cost of equity, the project is considered worthwhile, as it will create value for shareholders.

Cost of equity is calculated by adding the risk-free rate to the product of the equity’s beta and the market risk premium. A higher cost of equity indicates that shareholders require a higher return for the risk they are taking, which may lead the company to favor debt financing or to be more selective in its investment choices. Conversely, a lower cost of equity suggests that shareholders are willing to accept lower returns, which may encourage the company to pursue more equity financing and undertake a broader range of investment opportunities.

Why Cost of Equity Matters to Financial Advisors

Cost of equity is also a tool that financial advisors use when evaluating investment opportunities and making recommendations to clients. Cost of equity can help financial advisors assess a company’s fiscal health, growth prospects and potential returns, all of which are essential for making informed investment decisions on behalf of their clients.

If a company’s return on equity consistently falls below its cost of equity, it may indicate that the company is not generating sufficient returns to justify the risk taken by equity investors. This could be a red flag for financial advisors, as it suggests that the company may not be a suitable investment for their clients.

Understanding the cost of equity can also help financial advisors make informed decisions about portfolio allocation, risk managementand asset selection to meet their clients’ investment goals.

For example, a client with a high risk tolerance and a long investment horizon may be more suited to investments with a higher cost of equity, as they have the potential for greater returns over time. In this scenario, a financial advisor might allocate a larger portion of the client’s portfolio to growth-oriented stocks with higher costs of equity, while still maintaining some exposure to lower-risk investments to provide balance and stability.

Cost of equity is related to other important financial metrics that advisors use to assess investment opportunities, including return on equity (ROE) and the price-to-earnings (P/E) ratio.

ROE quantifies how profitable a company is by measuring how much profit it generates with the money shareholders have invested. On the other hand, the P/E ratio represents how much money an investor needs to invest in a company to receive $1 of that company’s earnings. By comparing a company’s ROE to its cost of equity and considering its P/E ratio, financial advisors can gain a more comprehensive understanding of a company’s financial performance and valuation relative to its peers.

How to Calculate Cost of Equity

There are two primary methods for calculating cost of equity:

The DDM estimates the cost of equity based on the company’s expected future dividends and its current stock price. The CAPM, on the other hand, calculates the cost of equity by considering the risk-free rate, the market risk premium and the company’s beta (a measure of its volatility relative to the market).

Calculating Cost of Equity Using DDM Formula

The DDM assumes that the value of a stock is equal to the present value of its future dividend payments. To calculate the cost of equity using the DDM, advisors and investors can use the following formula:

Cost of Equity = (Expected Dividend per Share / Current Market Price of Stock)
+ Dividend Growth Rate

This model relies on the assumption that the company will continue to pay dividends in the future and that the dividend growth rate can be accurately estimated. However, these assumptions may not always hold true, particularly for companies that have unpredictable dividend growth.

Each variable in the formula must be carefully determined to ensure an accurate estimate. The current stock price can be easily found on financial websites or stock exchanges, while estimating the dividend growth rate may require analyzing the company’s historical dividend growth and its future earnings prospects, which can be derived from analyst reports and management guidance.

For example, suppose a company’s current stock price is $50, and it is expected to pay a dividend of $2 per share next year. If the company’s dividend growth rate is estimated to be 5%, the cost of equity would be calculated as follows:

Cost of equity = ($2 / $50) + 0.05 = 0.04 + 0.05 = 0.09 or 9%

Calculating Cost of Equity Using CAPM Formula

Meanwhile, the CAPM assumes that investors are rational and risk-averse, and that they demand a higher return for taking on additional risk. This model relies on several assumptions, such as the existence of a perfect market, the absence of taxes and transaction costs and the ability of investors to borrow and lend at the risk-free rate.

The formula for CAPM is as follows:

Cost of Equity = Risk-Free Rate + Beta × (Market Return – Risk-Free Rate)

Each variable in the formula must be carefully defined and sourced:

The CAPM’s main advantage is its ability to incorporate market risk into the cost of equity calculation, providing a more comprehensive assessment of the required return for investors. However, accurately estimating beta and market returns can be challenging, as these variables are subject to estimation errors and may change over time. Moreover, the CAPM’s assumptions of a perfect market and rational investors may not always reflect reality, which can affect the accuracy of the cost of equity estimate.

Cost of Equity Example

Let’s consider an example scenario to illustrate the concept of cost of equity and its significance. Picture a company with a risk-free rate of 2%, an expected market return of 8%, and a Beta of 1.2.

To calculate the cost of equity, we’ll first subtract the risk-free rate from the expected market return (8% – 2%) to determine the market risk premium, which in this case is 2%. We’ll then multiply the company’s beta by the market risk premium to calculate the company-specific risk premium:

1.2 * 6% = 7.2%

Lastly, we’ll add the risk-free rate to the company-specific risk premium to obtain the cost of equity:

2% + 7.2% = 9.2%

Therefore, the cost of equity for this company is 9.2%.

Bottom Line

The cost of equity is used in corporate finance to determine the minimum rate of return a company must generate to satisfy its shareholders. Financial advisors rely on the cost of equity to make informed recommendations to clients, considering factors such as risk tolerance, investment horizon and financial goals. Calculating the cost of equity using methods like the dividend discount model (DDM) and the capital asset pricing model (CAPM) can enable an advisor to make more informed decisions for their clients.

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