How to Calculate Cost of Equity for WACC

The cost of equity represents the return that a company’s equity investors expect to receive for the risk they undertake by investing in the company’s shares. This expectation arises because investors forego other opportunities by placing their capital in a specific business. Understanding this required rate of return is fundamental for assessing a company’s financial health and its attractiveness as an investment, serving as a benchmark for performance.

The Role of Cost of Equity in WACC

The cost of equity is the rate of return a company needs to generate to satisfy its equity investors. Without meeting this expected return, a company may find it challenging to raise additional equity financing in the future.

The Weighted Average Cost of Capital (WACC) represents the average rate of return a company expects to pay to all its capital providers. WACC is an important metric used as a discount rate in various financial analyses, such as capital budgeting decisions and company valuations. An accurate calculation of the cost of equity is therefore essential for deriving a precise WACC.

WACC accounts for the proportion of equity and debt used to finance a company’s assets. Any miscalculation of the cost of equity can lead to an inaccurate WACC, potentially resulting in flawed investment decisions or an incorrect valuation of a business.

Calculating Cost of Equity Using the Capital Asset Pricing Model

The Capital Asset Pricing Model (CAPM) is a widely used method for estimating the cost of equity, particularly for publicly traded companies. It links the expected return on an asset to the expected market return and the asset’s sensitivity to market risk. The CAPM formula is expressed as: Cost of Equity = Risk-Free Rate + Beta × (Market Risk Premium).

The risk-free rate represents the return on an investment with no associated risk of financial loss. The yield on long-term U.S. Treasury bonds, such as the 10-year Treasury note, is commonly used as a proxy. For instance, if the 10-year U.S. Treasury yield is currently 4.0%, this value would be used as the risk-free rate in the CAPM calculation.

Beta measures a stock’s volatility or systematic risk in relation to the overall market. A beta of 1.0 indicates that the stock’s price moves with the market; a beta greater than 1.0 suggests higher volatility, while a beta less than 1.0 implies lower volatility. Beta values for publicly traded companies are readily available from financial data providers.

The market risk premium (MRP) is the expected return of the overall market above the risk-free rate. Estimating the MRP involves considering historical market performance or analyst projections. Historical data often suggests an MRP ranging from 3% to 6% for the U.S. market. For example, if the average historical return of the S&P 500 has been 10% and the risk-free rate is 4%, the MRP would be 6%.

Assume a company’s beta is 1.2, the current risk-free rate is 4.0%, and the market risk premium is estimated at 5.5%. Applying the CAPM formula, the cost of equity would be calculated as: 4.0% + 1.2 × 5.5%, resulting in 10.6%. This 10.6% represents the expected return shareholders require for investing in this company, given its risk profile relative to the market.

Calculating Cost of Equity Using the Dividend Discount Model

The Dividend Discount Model (DDM) offers an alternative approach to estimating the cost of equity, particularly useful for mature companies that pay consistent dividends. This model values a stock based on the present value of its future dividends, assuming those dividends grow at a constant rate indefinitely. The DDM formula for the cost of equity is: (Expected Dividend per Share / Current Stock Price) + Dividend Growth Rate.

The expected dividend per share refers to the dividend anticipated to be paid in the upcoming year. This can be estimated by taking the most recently paid annual dividend and multiplying it by one plus the expected dividend growth rate. For example, if a company recently paid a $2.00 dividend per share and its dividends are expected to grow by 5% annually, the expected dividend per share for the next year would be $2.10.

The current stock price is the prevailing market price at which the company’s shares are trading. It represents the collective market’s current valuation of the company’s equity.

The dividend growth rate is the constant rate at which dividends are expected to increase each year into perpetuity. This rate can be estimated by analyzing historical trends or analyst forecasts. For instance, a company with a consistent history of increasing dividends by 4% annually might use this figure.

Assume a company’s expected dividend per share for the next year is $2.10, its current stock price is $50.00, and its dividend growth rate is 4.0%. Using the DDM, the cost of equity would be calculated as: ($2.10 / $50.00) + 0.04, resulting in 8.2%. This 8.2% represents the estimated return required by investors based on the company’s dividend payouts and expected growth.

Finalizing WACC with Cost of Equity

Once the cost of equity has been calculated, it becomes a direct input into the Weighted Average Cost of Capital formula. The WACC formula integrates the cost of equity with the cost of debt, weighted by their respective proportions in the company’s capital structure. The WACC formula is: WACC = (Cost of Equity × % Equity) + (Cost of Debt × % Debt × (1 – Tax Rate)).

The calculated cost of equity is multiplied by the percentage of the company’s capital structure that is financed by equity. This percentage is determined by dividing the total market value of equity by the total market value of both equity and debt. For example, if a company’s market value of equity is $100 million and its market value of debt is $50 million, the equity weighting would be 66.67% ($100M / $150M).

The remaining components of the WACC formula account for the cost of debt, its proportion in the capital structure, and the tax benefits associated with interest payments on debt. The cost of debt is the interest rate a company pays on its borrowings, adjusted for the corporate tax rate. The WACC calculation provides a single discount rate that reflects the blended cost of financing a company’s assets.