Cost of Equity

What is the cost of equity?

The cost of equity is the required rate of return investors receive for an investment to compensate them for the risk they’re undertaking. It’s the return firms pay to their equity investors or shareholders as they grow capital.

Companies turn to equity management software to administer equity or its assets minus its liabilities. Sometimes referred to as cap table management software, these tools track and manage the complex processes of issuing equity and its potential cost. 

Why is the cost of equity important?

The cost of equity is need-to-know for investors to ensure their investments are worthwhile and beneficial. In terms of stock valuation, investors may look for their investments to increase by the cost of equity at a minimum.

It is an important calculation for investors, but business owners should also pay attention to their cost of equity if they want to appeal to those investors.

Cost of equity calculations

There are two ways to calculate the cost of equity: the dividend capitalization model (sometimes referred to as the dividend discount model) and the capital asset pricing model (CAPM). These two calculations use different variables, so the calculations for the same investment may differ. However, both models can help evaluate the risk of an investment.

• D1 is the yearly dividends per share or the total number of dividends that one share earns in one year.
• P0 is the current price of one share.
• g is the dividend growth rate. 

Suppose the yearly dividends of the stock for Company X is $5.55. The current price of one share is $140.45 with a dividend growth rate of 13%. Below is the cost of equity calculation of Company X’s stock:

0.169 or 16.9% = (5.55/140.45) + 0.13

• Rf is the interest rate of an investment with zero risk, otherwise known as the risk-free rate.
• βi  is the beta risk or volatility of the investment compared to the wider market.
• (E(Rm) - Rf) refers to the overall risk of investing in the stock market.

Suppose the beta of Company X’s stock is 0.54. The risk-free rate is 2.13%. The average stock market return is 10%. Below is the cost of equity calculation using the CAPM model:

0.063 or 6.3% = 0.0213 + 0.54 (0.1 - 0.0213)

Cost of equity vs. cost of capital

Although the cost of equity and cost of capital sound similar, they are two separate calculations. The cost of equity refers to the returns investors expect to see when investing in a business. The dividend capitalization model and capital asset pricing model (CAPM) are used to calculate the cost of equity. 

The cost of capital is a business' cost to raise capital funds. The cost of capital takes the cost of equity and debt into account and is known as the weighted average cost of capital (WACC).