How to Determine Cost of Equity Using 3 Key Methods

The cost of equity represents the return a company is expected to pay its equity investors to compensate them for the risk undertaken by investing their capital. It is a fundamental component of a company’s overall cost of capital, reflecting the compensation shareholders demand for placing their funds in a company’s stock rather than a risk-free alternative. This metric serves as a discount rate for valuing future cash flows generated by a business or investment.

For businesses, the cost of equity functions as a hurdle rate, the minimum acceptable rate of return a project or investment must achieve to be considered viable. If a potential project’s expected return falls below this hurdle rate, it may not be pursued, as it would not adequately compensate shareholders for the risk involved. Determining the cost of equity is crucial for making informed capital budgeting decisions, guiding companies in allocating resources to projects that are expected to create shareholder value. For investors, understanding a company’s cost of equity helps in assessing whether a stock or a private investment offers a sufficient return relative to its associated risk, ensuring their investment decisions align with their risk tolerance and return expectations.

Calculating Cost of Equity Using the Dividend Discount Model

The Dividend Discount Model (DDM) is a valuation method that calculates the intrinsic value of a stock based on the present value of its future dividends. When adapted to determine the cost of equity, it is often referred to as the Gordon Growth Model (GGM), which assumes that dividends grow at a constant rate indefinitely. This model posits that the current share price reflects the sum of all future dividends, discounted back to the present at the equity holder’s required rate of return.

To apply the Gordon Growth Model for calculating the cost of equity, three key inputs are necessary. The first is the current stock price (P0), which represents the market value of one share of the company’s stock. This price is readily available from financial markets. The second input is the expected dividend per share for the next period (D1), typically projected by taking the most recent dividend paid (D0) and increasing it by the estimated constant growth rate of dividends.

The third and often most challenging input to estimate is the constant growth rate of dividends (g). This growth rate is an assumption about the future rate at which the company’s dividends are expected to increase over time. Several approaches can be used to estimate ‘g’. One common method involves analyzing the company’s historical dividend growth, calculating the average annual growth rate over a significant period, such as the last five or ten years. Another approach utilizes analyst forecasts, which provide professional estimates of future dividend growth based on their research.

A more sophisticated method for estimating ‘g’ is the sustainable growth rate. This rate represents the maximum rate at which a company can grow without needing to issue new equity or increase its financial leverage. The sustainable growth rate is calculated by multiplying the company’s return on equity (ROE) by its earnings retention rate (1 – dividend payout ratio). For instance, if a company has a consistent ROE of 15% and retains 60% of its earnings, its sustainable growth rate would be 9% (0.15 0.60). Using this rate provides a more internally consistent estimate aligned with the company’s profitability and dividend policy.

Once these inputs are determined, the cost of equity (Ke) can be calculated using the Gordon Growth Model formula: Ke = D1 / P0 + g. For example, if a company’s current stock price (P0) is $50, its expected dividend for the next period (D1) is $2.50, and the constant growth rate of dividends (g) is estimated at 5% (0.05), the calculation would be: Ke = $2.50 / $50 + 0.05. This results in a cost of equity of 10%. This 10% represents the minimum return shareholders expect to earn from their investment in the company.

Calculating Cost of Equity Using the Capital Asset Pricing Model

The Capital Asset Pricing Model (CAPM) is a widely recognized financial model that links the expected return of an asset to its systematic risk. This model provides a framework for determining the appropriate required rate of return for an equity investment, considering its risk relative to the overall market. CAPM suggests that investors should be compensated for both the time value of money and the systematic risk they undertake.

To calculate the cost of equity using CAPM, three specific inputs are required. The first input is the risk-free rate (Rf), which represents the theoretical return on an investment with zero risk. In practice, the yield on long-term U.S. Treasury securities, such as 10-year or 20-year Treasury bonds, is commonly used as a proxy for the risk-free rate. The selection of the appropriate maturity for the Treasury yield should generally align with the investment horizon of the project or valuation being undertaken.

The second input is the market risk premium (Rm – Rf), which is the expected return of the overall market (Rm) minus the risk-free rate (Rf). This premium represents the additional return investors expect for investing in the broad market compared to a risk-free asset. Estimating the market risk premium often involves using historical data, such as the average difference between stock market returns and Treasury bond returns over several decades. Alternatively, an implied market risk premium can be derived from current market valuations and expected future earnings. This component is subjective and can significantly influence the resulting cost of equity.

The third critical input is Beta (β), which measures a stock’s volatility or systematic risk in relation to the overall market. A beta of 1 indicates that the stock’s price moves in line with the market. A beta greater than 1 suggests the stock is more volatile, while a beta less than 1 indicates less volatility. Beta is typically derived through statistical regression analysis, comparing the historical price movements of the stock to those of a broad market index, such as the S&P 500. Financial data providers often publish calculated betas for publicly traded companies.

Once these inputs are identified, the CAPM formula for the cost of equity (Ke) is: Ke = Rf + β (Rm – Rf). For instance, if the risk-free rate (Rf) is 3%, the company’s beta (β) is 1.2, and the market risk premium (Rm – Rf) is 6%, the calculation would be: Ke = 0.03 + 1.2 (0.06). This calculation yields a cost of equity of 10.2%, indicating the expected return shareholders require given the systematic risk of the company’s stock relative to the market.

Calculating Cost of Equity Using the Bond Yield Plus Risk Premium Method

The Bond Yield Plus Risk Premium (BYPRP) method offers a practical, albeit generally less precise, approach to estimating the cost of equity. This method is particularly useful for privately held companies or those that do not pay consistent dividends, making the Dividend Discount Model less applicable, and for situations where detailed market data for CAPM inputs might be scarce. It operates on the principle that equity, being riskier than debt, should command a higher return than the company’s long-term debt.

The method requires two primary inputs. The first is the company’s long-term debt yield. This represents the yield to maturity on the company’s outstanding long-term bonds. If the company has publicly traded bonds, their yield to maturity can be directly observed from market data. For companies without publicly traded debt, this yield can be estimated based on the company’s credit rating and the prevailing yields on comparable corporate bonds in the market. Financial institutions and credit rating agencies provide benchmarks for different credit tiers, which can assist in this estimation.

The second input is an equity risk premium, also known as a risk spread, which is added to the debt yield. This premium accounts for the additional risk associated with investing in a company’s equity compared to its debt. Equity holders face greater risk because they are residual claimants, meaning they are paid only after debt holders in the event of liquidation, and their returns are not guaranteed like interest payments to bondholders. Estimating this equity risk premium is subjective and often relies on historical spreads between equity and debt returns for similar companies or industries.

Industry averages or expert judgment can also inform the selection of this premium. For example, a common range for this premium might be between 3% and 5%, depending on the industry and specific company characteristics. A company in a more volatile or uncertain industry might warrant a higher risk premium than one in a stable, mature sector. This component is crucial because it bridges the gap between the relatively lower risk of debt and the higher risk of equity.

The formula for the Bond Yield Plus Risk Premium method is straightforward: Cost of Equity = Yield on Company’s Long-Term Debt + Equity Risk Premium. For example, if a company’s long-term debt has a yield to maturity of 6%, and an appropriate equity risk premium for its industry is determined to be 4%, the cost of equity would be calculated as: 0.06 + 0.04. This results in a cost of equity of 10%. This method provides a quick estimate, acknowledging the higher risk profile of equity investments compared to debt.