How to Calculate the Cost of Common Stock

The cost of common stock represents the rate of return a company must earn on its investments to maintain the current value of its stock. This metric is a significant component in financial decision-making for businesses and investors. It helps companies evaluate potential projects and investment opportunities by providing a benchmark for the minimum acceptable return. For investors, understanding this cost offers insight into the company’s financial health and its ability to generate value. Several established methods exist to calculate this important financial measure, each offering a different perspective on the underlying factors that influence a company’s equity value.

Gathering Necessary Information

Calculating the cost of common stock requires several specific pieces of information, which serve as inputs for the various models. The current stock price refers to the market price at which a company’s shares are currently trading. This value is readily available from financial market data providers and stock exchanges. Expected future dividends represent the anticipated cash distributions a company plans to make to its shareholders over upcoming periods. Analyzing a company’s dividend history and public guidance can help estimate these future payments.

The dividend growth rate indicates the constant rate at which a company’s dividends are expected to increase over time. This rate can be estimated by looking at historical dividend growth, analyst forecasts, or by using a company’s retention ratio and return on equity. The risk-free rate is the theoretical rate of return of an investment with zero risk. This rate is typically approximated by the yield on long-term U.S. Treasury bonds, such as 10-year or 20-year Treasury notes, as these are considered to have minimal default risk.

The market risk premium is the additional return investors expect for holding a diversified portfolio of stocks over the risk-free rate. This premium compensates investors for the inherent volatility and risk associated with equity investments compared to risk-free assets. It is often estimated by looking at historical average returns of the stock market compared to Treasury yields over long periods. A company’s beta measures the volatility of its stock price relative to the overall market. A beta greater than 1 suggests the stock is more volatile than the market, while a beta less than 1 indicates less volatility. This figure can be found on financial data websites or calculated using historical stock price data.

The current yield on the company’s long-term debt refers to the interest rate a company is currently paying on its outstanding long-term bonds. This yield reflects the market’s assessment of the company’s credit risk. It can be obtained from bond market data providers or by examining the company’s recent bond issuances. An equity risk premium, an additional return investors demand for holding a company’s stock over its debt, is also necessary for some approaches.

Applying the Dividend Discount Model

The Dividend Discount Model (DDM) is a method used to estimate the cost of common stock by considering the present value of all future dividends. This model is particularly useful for companies that have a consistent history of paying dividends and whose dividends are expected to grow at a relatively stable rate. The fundamental idea behind the DDM is that a stock’s value is derived from the income stream it provides to investors through dividends.

The formula for the cost of common stock (Ke) using the DDM, assuming a constant growth rate, is expressed as: Ke = (D1 / P0) + g. Here, D1 represents the expected dividend per share in the next period, and P0 is the current market price per share of the stock. The variable ‘g’ stands for the constant growth rate of dividends. This formula suggests that the cost of equity is the sum of the dividend yield and the dividend growth rate.

To apply this model, consider a company with a current stock price (P0) of $50. If the company just paid a dividend (D0) of $2.00, and dividends are expected to grow at a constant rate (g) of 5% per year, the first step is to calculate the expected dividend for the next period (D1). D1 would be $2.00 (1 + 0.05) = $2.10.

With D1 calculated, the inputs can be directly placed into the DDM formula. So, Ke = ($2.10 / $50) + 0.05. Performing the calculation, Ke = 0.042 + 0.05, which equals 0.092 or 9.2%. This 9.2% represents the estimated cost of common stock for the company according to the Dividend Discount Model.

Applying the Capital Asset Pricing Model

The Capital Asset Pricing Model (CAPM) offers another widely recognized approach for determining the cost of common stock, focusing on the relationship between risk and expected return. This model posits that an investor’s required rate of return on an investment is equal to the risk-free rate plus a premium for the systematic risk undertaken. Systematic risk, also known as market risk, is the non-diversifiable risk that affects the entire market.

The CAPM formula for the cost of common stock (Ke) is: Ke = Rf + Beta (Rm – Rf). In this equation, Rf signifies the risk-free rate, which accounts for the time value of money without any associated risk. Beta measures the stock’s sensitivity to market movements, indicating how much the stock’s price tends to move relative to the overall market. The term (Rm – Rf) represents the market risk premium, which is the additional return investors anticipate from investing in the broader market compared to a risk-free asset.

To illustrate the CAPM calculation, assume a risk-free rate (Rf) of 3%. Suppose the company’s beta is 1.2, indicating it is slightly more volatile than the market. If the expected market return (Rm) is 10%, then the market risk premium (Rm – Rf) would be 10% – 3% = 7%.

Plugging these values into the CAPM formula, Ke = 0.03 + 1.2 (0.10 – 0.03). This simplifies to Ke = 0.03 + 1.2 0.07. Continuing the calculation, Ke = 0.03 + 0.084, which results in Ke = 0.114 or 11.4%. This 11.4% is the estimated cost of common stock for the company as determined by the Capital Asset Pricing Model, reflecting the compensation investors require for the stock’s specific risk profile relative to the market.

Applying the Bond-Yield-Plus-Risk-Premium Approach

The Bond-Yield-Plus-Risk-Premium Approach provides a simpler, albeit less precise, method for estimating the cost of common stock. This approach recognizes that equity investments generally carry more risk than a company’s debt, and therefore, investors require a higher return for holding common stock compared to bonds. It builds upon the observable yield of a company’s long-term debt by adding an estimated equity risk premium.

The formula for the cost of common stock (Ke) using this approach is: Ke = Yield on Company’s Long-Term Debt + Equity Risk Premium. The yield on the company’s long-term debt reflects the market’s assessment of the company’s creditworthiness and the base return demanded by debt holders. The equity risk premium is an additional return, typically ranging from 3% to 5%, that compensates equity investors for the increased risk and volatility associated with owning common stock compared to the company’s bonds. This premium accounts for factors like residual claim on assets and income, and voting rights.

For example, if a company’s outstanding long-term bonds are currently yielding 6%, this represents the return debt holders are receiving. If an appropriate equity risk premium for similar companies is estimated to be 4%, this additional percentage is added to the bond yield.

Applying these figures to the formula, Ke = 0.06 + 0.04. This calculation yields a cost of common stock (Ke) of 0.10 or 10%. This 10% indicates the estimated return investors expect from the company’s common stock, reflecting both the company’s debt cost and the additional compensation for equity risk.