What Is The Cost Of Equity? (With Formulas And Examples)

Indeed Editorial Team

Updated 11 October 2022

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Determining the cost of equity is essential because it helps investors determine whether to invest in a company. Investors calculate this equity cost to understand how much money they are likely to make and determine the relative risk of investing in a company. If you have an interest in becoming a financial analyst or asset trader, knowing how to calculate the equity cost might be beneficial.

In this article, we define what equity cost is, explore its importance, see who calculates it, detail two key formulas for calculating equity cost, review the dividend discount model, explain the steps to calculate it and review examples.

What Is The Cost Of Equity?

Cost of equity refers to the rate of return that shareholders expect to receive for their investment. It is the minimum return shareholders can expect and is an essential aspect of the capital structure because it assesses the relative attractiveness of investments, including external and internal projects. The equity cost helps measure the risk of buying stocks in a particular company. Typically, a lower equity cost means a company attracts more buyers because they are likely to make money on their investment. Understanding the meaning of equity and the required rate of return might help calculate equity cost:

  • Equity: Equity refers to the value of an asset after paying its liabilities, such as debts or taxes. It represents the money returned to shareholders after liquidating assets and paying debts.

  • Required rate of return: The required rate of return refers to the lowest rate an investor hopes to receive based on their investment. Typically, this rate might differ from one investment to another depending upon the risk associated with the equity investment.

Related: What Is Capital Structure? (With Types And Ways To Use It)

Why Is The Cost Of Equity Important?

The equity cost is important because it helps in stock valuation. When investors invest in a company, they expect their investment to increase, at least by the equity cost. It determines the value of an equity investment. Typically, the higher the risk, the higher the equity cost. As a result, investors consider this cost before making an investment decision. It helps a group or individual decide whether it is advisable to invest in a particular security and how much of that security to buy. Equity cost is an excellent planning tool for parties involved in securities handling.

Related: What Is Growth Equity? (With Definition, Pros, Cons And FAQs)

Who Calculates The Equity Cost?

Financial professionals, such as accountants and financial analysts, use equity cost calculation to make intelligent investment decisions and guide their clients and businesses on best practices to operate a business. Individuals and shareholders use this calculation before making potential investment decisions in a company. A company might calculate its equity cost to inform business decisions and communicate with potential stakeholders. Periodically, assessing the equity cost can help shareholders assess their financial portfolio and make adjustments.

Related: What Is A Shareholder? (With Rights And Responsibilities)

Formula To Calculate The Equity Cost

To understand how equity cost works, it is essential to understand the formula you can use to calculate it. There are several methods for calculating the equity cost:

Capital asset pricing model (CAPM)

The capital asset pricing model, or CAPM, accounts for the risk associated with the stock. Financial analysts might use this model when trading in stocks that do not offer dividends. Though the formula is complex, it provides accurate results. The first step of using the CAPM is subtracting the risk-free rate of return from the market's rate of return. Next, multiply it with the beta of the investment and add that number to the risk-free return rate. The formula for calculating the equity cost is:

Ra = Rrf + [B x (Rm – Rrf)]

Here is an explanation of each variable:

  • Ra: equity cost in percentage

  • Rrf: risk-free rate of return, which represents the interest rate an investor expects to earn on investment with zero risk

  • B: beta of the investment, which measures a stock's volatility compared to the overall market

  • Rm: market's rate of return, which refers to the net gain or loss of an investment over a specified period, expressed as a percentage of the initial investment cost.

Related: Assets Vs Income: Definition And Differences (With Types)

Dividend Discount Model (DDM) Or Gordon Model

Analysts often prefer using the DDM, or the Gordon model, when speculating on future stock prices. This model helps in delivering the value of a stock's dividend. Many analysts use the model while selecting appropriate stocks. As the DDM considers dividends in the calculation and not all companies pay dividends, DDM is a less preferred choice for calculating the equity cost. When using the DDM model, focus on dividing the yearly dividends by the share's current price and adding the dividend growth rate. The formula for calculating DDM is:

Equity cost = (Next year's annual dividend / Current stock price) + Dividend growth rate

For using the formula, it is essential to understand each term:

  • Current share price: The current share price refers to the price of the most recently traded stock.

  • Dividend growth rate: The dividend growth rate is the growth percentage that a stock's dividend undergoes for a specific period.

  • Dividends: A dividend refers to the cash, reward and earnings that a company provides to its shareholders from its profits.

Related: What Is Debt Financing? (With Advantages And Disadvantages)

How To Calculate The Equity Cost?

Use these steps to calculate the equity cost of a shareholder:

1. Determine the variables of the formula used

Whether you use the CAPM or the DDM model, knowing the values of the variables in each formula is essential for calculating the equity cost. If you use the CAPM model, you require a risk-free return rate, the beta of the investment and the market's rate of return. If you use the DDM model, you require the value of the current stock's price, next year's annual dividend and dividend growth rate. Once you have the values of these variables, enter them into the equation.

Related: What Are Shares Outstanding? (Definition And Calculation)

2. Calculate the equity cost

After entering the values into the formula, the resulting value is the equity cost of the investment, expressed as a percentage. Typically, the lower the equity cost, the greater the chances of encouraging an investor to invest. Also, the equity cost is higher than debt and provides a higher return rate.

Related: What Is An Angel Investor? (Advantages And Disadvantages)

Examples For Calculating The Equity Cost

Here are a few examples for calculating the equity cost:

Dividend discount model

Here is an example of calculating the equity cost using the DDM:

Reyansh is a stockbroker and helps clients make intelligent investment decisions. In October 2019, Reyansh purchased 500 shares costing ₹5,00,000, with each share costing ₹1000. In 2020, Reyansh earned a dividend of ₹50 per share. His 500 shares provide a dividend of ₹25,000. In 2022, Reyansh expects the investment to give ₹80 per share as a dividend. His 500 shares are likely to provide a dividend of ₹40,000.

The growth rate of dividend = (80 – 50)/50 = 0.6 or 60%
The current share prices are ₹1050 each or ₹5,25,000 in total.
Equity cost = (Next year's annual dividend / Current stock price) + Dividend growth rate

= (80/1050) + 0.60
= 0.676 or 67.6%

Related: What Is A Stock Option? (With Definition, Types And Benefits)

Capital asset pricing model

Here is an example of calculating the equity cost using the CAPM model:

Vivek helps his clients minimise portfolio risk by widening the portfolio. When deciding whether to invest in a stock, Vivek calculates the equity cost. For one such stock, the risk-free rate of return is 6% and he expects the market to rise by 8% during the next year. The investment's beta is 1.5, suggesting that the investment is riskier compared to other investments in the market. Using the CAPM model, Vivek calculates the equity cost.

Ra = Rrf + [B x (Rm – Rrf)]
= 0.06 + [1.5 x (0.08 – 0.06)]
= 0.09 or 9%

The equity cost is 9% is higher than the market's average. Vivek recommends buying and holding the stock for the moment.

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