How to Properly Calculate the Cost of Equity

The cost of equity quantifies the return a company is expected to pay to its equity investors. This figure compensates investors for the risk they assume by putting their capital into the business. This cost directly influences a company’s investment decisions and valuation. It is also an input for the Weighted Average Cost of Capital (WACC), which blends the cost of equity with the cost of debt to provide a comprehensive look at a company’s total cost of capital.

This metric is used in financial models, including the Discounted Cash Flow (DCF) analysis. In a DCF model, the cost of equity is used to discount future cash flows to their present value, providing an estimate of a company’s intrinsic worth. An accurate calculation allows for more precise business valuation, helping guide corporate strategy, mergers, and capital budgeting. It provides a benchmark that new projects must exceed to create value for shareholders.

Key Inputs for Cost of Equity Models

Before calculating the cost of equity, several data points must be gathered from reliable financial sources. These inputs form the foundation of the most common calculation models. The accuracy of each piece of data directly impacts the final cost of equity figure.

A primary input is the risk-free rate of return. This is the theoretical return on an investment that has zero risk. In practice, the yield on long-term government bonds is used as a proxy for this rate, as government debt is considered to have a very low risk of default. The most frequently used benchmark is the yield on the 10-year or 20-year U.S. Treasury bond.

Another component is the equity market risk premium (MRP). This figure represents the additional return that investors expect for investing in the stock market over the risk-free rate. The MRP compensates investors for taking on the higher risk of equity investments compared to risk-free government debt. This premium is an estimate derived from historical data and forward-looking market analyses, with financial data providers and academic sources publishing their own estimates.

The beta of a company’s stock is also required. Beta measures the volatility of a specific stock in comparison to the overall stock market, which is represented by an index like the S&P 500. A beta of 1.0 indicates that the stock’s price is expected to move in line with the market. A beta greater than 1.0 suggests the stock is more volatile than the market, while a beta less than 1.0 suggests it is less volatile.

For certain calculation methods, dividend-related information is needed. The expected dividend per share represents the total dividend a company is anticipated to pay for each share over the next year, often based on the company’s most recent dividend payment or management guidance. The dividend growth rate is the rate at which a company’s dividend is expected to grow over time. This can be estimated by analyzing historical dividend growth or by using forecasts from financial analysts.

Applying the Capital Asset Pricing Model (CAPM)

The Capital Asset Pricing Model (CAPM) is a common method for determining the expected return on an equity investment. It provides a framework for calculating the cost of equity by incorporating the risk-free rate, market volatility, and a stock’s specific risk profile. The model’s output gives a required rate of return that compensates the investor for the time value of money and the associated risk.

The formula for CAPM is: Cost of Equity = Risk-Free Rate + Beta (Equity Market Risk Premium). The calculation begins with the risk-free rate, establishing a baseline return for a no-risk investment. The model then adjusts this baseline upward to account for the additional risk of investing in the equity markets.

This adjustment is achieved by multiplying the company’s beta by the equity market risk premium. This part of the formula is known as the stock’s risk premium. It quantifies the excess return required for the specific stock’s volatility relative to the broader market. A higher beta or a higher market risk premium will result in a larger stock-specific risk premium and a higher cost of equity.

To illustrate, assume the current yield on a 10-year U.S. Treasury bond (the risk-free rate) is 4.4%. The determined equity market risk premium is 5.0%. If the company in question has a beta of 1.2, it is more volatile than the overall market. Inserting these values into the CAPM formula results in the following calculation: Cost of Equity = 4.4% + 1.2 (5.0%). The result is a cost of equity of 10.4%, which represents the minimum return a company must generate to satisfy its equity investors.

Using the Dividend Discount Model (DDM)

An alternative approach for calculating the cost of equity is the Dividend Discount Model (DDM). This method is well-suited for mature, stable companies that have a history of paying consistent and growing dividends. The model’s logic is based on the principle that a stock’s value is the present value of all its future dividend payments. By rearranging the formula, it can be used to solve for the cost of equity.

The most common version of the DDM used for this purpose is the Gordon Growth Model. The formula is: Cost of Equity = (Expected Dividend per Share / Current Market Value of Stock) + Dividend Growth Rate. This calculation requires the expected dividend for the next period, the current price of the company’s stock, and the constant rate at which dividends are expected to grow indefinitely.

The first part of the formula, (Expected Dividend per Share / Current Market Value of Stock), represents the dividend yield. This component reflects the return an investor receives in the form of dividends relative to the stock’s price. The second part, the dividend growth rate, accounts for the capital gains portion of the total return, representing the appreciation in stock value driven by the growth in future earnings and dividends.

For a practical example, imagine a company whose stock is currently trading at $100 per share. This company is expected to pay a dividend of $3.00 per share in the upcoming year, and its dividends are projected to grow at a steady rate of 5% per year. Using the Gordon Growth Model, the calculation would be: Cost of Equity = ($3.00 / $100) + 5%. This simplifies to 3% + 5%, yielding a cost of equity of 8%.

An Alternative Calculation Method

Beyond the more prevalent CAPM and DDM approaches, another technique is the Bond Yield Plus Risk Premium (BYPRP) method. This method is straightforward and relies on the financial principle that equity investors should demand a higher return than bondholders from the same company. This is because equity holders are in a subordinate position to debt holders in the capital structure, making their investment inherently riskier.

The formula for this approach is: Cost of Equity = Yield on the Company’s Long-Term Debt + Equity Risk Premium. The starting point is the current yield to maturity on the company’s long-term bonds. This yield represents the return required by the company’s creditors.

To this bond yield, a specific equity risk premium is added. This premium is not the same as the broad market risk premium used in CAPM. It is a subjective figure meant to compensate equity investors for the additional risk they take on compared to the company’s bondholders. Analysts add a premium of between 3% and 6%, though this can vary based on the company’s specific financial health.

For example, if a company’s long-term bonds have a yield of 6% and an analyst determines an appropriate equity risk premium is 4%, the estimated cost of equity would be 10%.