Cost of equity calculator

The cost of equity is a financial metric used to estimate the return required by investors to hold shares of a company’s stock. It represents the minimum rate of return a company must generate to satisfy its shareholders.

Ian Hawkins

Page written by Ian Hawkins. Last reviewed on July 17, 2024. Next review due April 1, 2025.

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Cost of equity

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What is the cost of equity?

The cost of equity represents the return required by investors for holding a company’s stock. It reflects the opportunity cost of investing in the company’s equity rather than alternative investments with similar risk profiles.

How to calculate cost of equity

To calculate the cost of equity, you can use the Capital Asset Pricing Model (CAPM) or the Dividend Discount Model (DDM). I’ll explain both methods:

  1. Capital asset pricing model (CAPM): The CAPM calculates the cost of equity based on the risk-free rate of return, the expected market return, and the company’s beta (a measure of the stock’s volatility relative to the overall market). The formula for calculating the cost of equity using CAPM is:

    Cost of equity = risk-free rate + beta × (market return – risk-free rate)

    Here’s how to calculate it:

  • Determine the risk-free rate: Find the current risk-free rate, usually the yield on government bonds, with a similar maturity to the investment horizon.
  • Determine the market return: Estimate the expected return of the overall market, typically using historical market data.
  • Determine the company’s beta: Beta measures the sensitivity of the company’s stock price to market fluctuations. You can find beta values for publicly traded companies from financial websites or databases.
  • Plug in the values into the formula: Substitute the risk-free rate, market return, and company’s beta into the formula to calculate the cost of equity.
  1. Dividend discount model (DDM): The DDM calculates the cost of equity based on the company’s expected dividends and the expected growth rate of those dividends. The formula for calculating the cost of equity using DDM is:

    Cost of Equity = Dividends per share / stock price + dividend growth rate

    Here’s how to calculate it:

  • Determine the expected dividends per share: Estimate the expected dividends the company will pay to its shareholders in the future. This can be based on historical dividends or projected future dividends.
  • Determine the current stock price: Find the current market price per share of the company’s stock.
  • Determine the expected dividend growth rate: Estimate the rate at which the company’s dividends are expected to grow over time.
  • Plug in the values into the formula: Substitute the dividends per share, stock price, and dividend growth rate into the formula to calculate the cost of equity.

Please note that both methods have their limitations and should be used in conjunction with other financial analysis tools when evaluating the cost of equity.

Example

As mentioned earlier, there are two ways to calculate the cost of equity. The first is based on the CAPM model, and the second is the Dividend discount model (DDM) or the dividend capitalization model. The latter is simpler, but it can only be used if the company is paying dividends.

Cost of Equity Formula based on CAPM Model:

Cost of Equity=Risk-free rate of return+β×(Market rate of return−Risk-free rate of return)

Formula based on the Dividend Capitalization Model:

Cost of Equity=(DPS/CSP)+GRD

Let’s go through an example using the dividend capitalization model. Imagine a company with a current share price of $100. The company announced a dividend of $3 per share this year, which is expected to grow by 4% annually. The cost of equity for this company is calculated as follows:

Cost of Equity=($3/$100)+4%=7%

We can understand this value as the company’s cost. To obtain an additional $100 in cash from investors right now, they would theoretically have to pay them $107 in the future.

Cost of equity vs. cost of debt: What is the difference?

The cost of equity represents the return required by equity investors, while the cost of debt reflects the interest rate paid by a company on its borrowed funds. Equity investors bear more risk than debt holders and, and therefore require a higher return. The cost of equity is often higher than the cost of debt due to the increased risk associated with equity investments.

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