What Is the Cost of Equity Formula?

The cost of equity formula is a financial metric that represents the return investors expect for holding a company’s stock. This formula can help you evaluate whether a company’s stock is generating adequate returns relative to its risk level. This is helpful for investors and companies alike, as it affects investment decisions, valuation and the overall cost of capital. By using the cost of equity formula, you can assess a company’s potential to meet your return expectations based on its risk profile and market conditions. 

A financial advisor can help you analyze investments and manage your investment portfolio. 

What Is the Cost of Equity Formula?

The cost of equity formula calculates the return that compensates for the risks associated with holding a company’s stock. The two main formulas for determining the cost of equity are the capital asset pricing model (CAPM) and dividend discount model (DDM). Each formula serves a different purpose, with CAPM being the more widely used method for publicly traded companies and DDM focusing on dividend-paying stocks.

Capital Asset Pricing Model (CAPM)

The CAPM formula is:

Cost of Equity (CAPM) = Risk-Free Rate of Return + Beta × (Market Rate of Return – Risk-Free Rate of Return)

• Risk-free rate of return: The return on a risk-free asset, usually represented by government bonds, as they are considered the safest investments.
• Beta: A measure of the stock’s volatility relative to the overall market. A beta above 1 indicates the stock is more volatile than the market, while a beta below 1 means it is less volatile.
• Market rate of return: The expected return on the overall market, typically represented by a broad index like the S&P 500.

For example, if the risk-free rate is 2%, the market return is 8% and the stock has a beta of 1.5, the cost of equity would be calculated as follows:

Cost of Equity = 2% + 1.5 × (8% – 2%) = 2% + 9% = 11%

In this example, the cost of equity is 11%, meaning investors expect an 11% return on their investment to compensate for the risk associated with this stock.

Dividend Discount Model (DDM)

The DDM formula is:

Cost of Equity (DDM) = (Dividends per Share / Current Stock Price) + Growth Rate of Dividends

This formula is most appropriate for companies that pay regular dividends and have a predictable dividend growth rate. The DDM assumes that dividends will continue to grow at a constant rate over time.

For example, if a company’s stock price is $50, the annual dividend is $2 per share, and the dividend growth rate is 4%, the cost of equity can be calculated as follows:

Cost of Equity = ($2 / $50) + 4% = 0.04 + 0.04 = 8%

In this case, the cost of equity is 8%, indicating that investors expect an 8% return based on the company’s dividend payments and anticipated growth.

Both formulas provide valuable insights for investors and companies by highlighting the expected rate of return for shareholders. Companies with a high cost of equity may face challenges in raising funds, while a lower cost of equity can indicate greater investor confidence and a stable financial outlook.

Why Is the Cost of Equity Formula Important?

The cost of equity formula is important for both investors and companies, as it determines the return required to justify investing in a company’s stock. 

For investors, understanding the cost of equity helps evaluate whether a stock is worth the risk. If the company’s returns exceed the cost of equity, it may be a more attractive investment, as it indicates potential for growth and profitability.

For companies, the cost of equity represents the minimum return they need to achieve to satisfy shareholders. It serves as a benchmark for financial performance, guiding corporate decisions on projects, expansions and financing. Companies often compare the cost of equity to the returns on prospective investments. If expected returns exceed the cost of equity, the investment may be worthwhile. 

The cost of equity also plays a role in the weighted average cost of capital (WACC). This combines the costs of debt and equity to determine a company’s overall cost of capital. A lower cost of equity can lead to a lower WACC, making it easier for companies to finance growth initiatives.

Cost of Equity vs. Cost of Debt

The cost of equity and the cost of debt are both components of a company’s capital structure, but they represent different aspects of financing. The cost of equity is the return required by shareholders, reflecting the risk associated with owning stock. The cost of debt, on the other hand, is the effective interest rate a company pays on its borrowed funds. 

While the cost of equity is generally higher than the cost of debt due to its riskier nature, debt is typically more affordable because interest payments are tax-deductible. A balanced capital structure with both debt and equity can lower a company’s overall cost of capital, enhancing its ability to invest in growth opportunities.

Frequently Asked Questions

How Is the Cost of Equity Used in Financial Analysis?

The cost of equity is used to assess whether a company’s projects or investments are generating adequate returns. It is also a component of the weighted average cost of capital (WACC), a metric which helps determine a company’s overall cost of capital and informs decisions on potential investments.

Can the Cost of Equity Change Over Time?

Yes, the cost of equity can change based on shifts in the risk-free rate, market conditions and the company’s beta. Changes in dividend policies or growth rates can also affect the cost of equity if using the DDM.

Why Is the Cost of Equity Higher Than the Cost of Debt?

The cost of equity is generally higher than the cost of debt because equity investors take on more risk by investing in a company’s stock. Unlike debt holders, shareholders are not guaranteed returns and only earn dividends if the company is profitable. In order to adequately compensate them for this added risk, they require a greater return on equity. 

Bottom Line

The cost of equity formula helps investors and companies gain insight into the return required to justify investing in a company’s stock. By calculating the cost of equity, investors can assess the potential returns relative to the associated risks and companies can evaluate their financial performance against shareholder expectations. Whether using the CAPM or DDM, understanding the cost of equity helps investors and businesses make informed decisions that align with their financial goals and risk tolerance.

Investment Planning Tips

• A financial advisor can help you estimate expected returns, assess risk factors and interpret results. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
• If you want to diversify your portfolio, here’s a roundup of 13 investments to consider. 

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