Cost of Equity

In the world of investments and finance, the term “cost of equity” is essential for evaluating company performance, making investment decisions, and managing financial strategy. Whether you’re a new investor or someone trying to understand how businesses assess risks and returns, knowing how the cost of equity works is crucial.

Table of Contents

What is the Cost of Equity?
Understanding Cost of Equity
Importance of Cost of Equity in Valuation
Calculation of Cost of Equity
Example of Cost of Equity
Frequently Asked Questions

What is the Cost of Equity?

The cost of equity refers to the return that a company must generate to compensate shareholders for the risk of investing in its stock. In simpler terms, it’s the minimum return investors expect when they choose to buy and hold a company’s shares instead of investing in risk-free assets, like government bonds.

From a company’s point of view, this is the price it pays for using shareholders’ money to fund operations or growth. Investors are taking on risk, and they want to be rewarded appropriately for that.

Understanding Cost of Equity

Let’s break this down a bit further.

Companies typically raise funds in two ways:

Debt, which includes loans and bonds, pays interest.
Equity, where they sell shares and give investors ownership in the business.

The cost of equity isn’t as straightforward as interest on debt—there’s no fixed payment. Instead, the return comes from share price appreciation and dividends. However, investors expect this return to match or exceed what they could earn elsewhere.

The higher the risk of the investment, the higher the return investors demand. This risk-return balance is the foundation for calculating the cost of equity.

Importance of Cost of Equity in Valuation

The cost of equity has several critical applications in business and investing:

Investment Valuation: It serves as the discount rate in valuation models, such as the Discounted Cash Flow (DCF) method, which helps determine the present value of future earnings.

Capital Budgeting: Before starting new projects or expanding operations, companies use the cost of equity to decide if the potential return is worth the risk.

Capital Structure Planning: The cost of equity influences the optimal mix of equity versus debt a company should use in financing. Companies strive to optimise this mix to reduce their overall cost of capital.

Performance Benchmark: A company must earn returns greater than its cost of equity to create value for its shareholders. If it consistently falls short, it may be a sign of poor financial health.

Calculation of Cost of Equity

There are two main approaches to calculating the cost of equity. The method chosen often depends on the availability of data and the nature of the company.

Dividend Capitalisation Model (DCM)

This model is suitable for companies that regularly pay dividends.

Formula:

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

Example:

A Singapore-listed company pays an annual dividend of SGX 1.20. Its current share price is SGX 30, and dividends are expected to grow by 4% annually.

Cost of Equity = (1.20 / 30) + 0.04 = 0.04 + 0.04 = 8%

This model assumes stable dividend growth, which may not apply to every company.

Capital Asset Pricing Model (CAPM)

The CAPM is widely used because it applies to all companies, regardless of whether they pay dividends.

Formula:

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

Risk-Free Rate: Yield on long-term government bonds, e.g., US 10-Year Treasury Bonds.

Beta: A measure of how volatile the stock is compared to the market.

Market Return: The expected return of the overall stock market.

Example (US Market):

Risk-Free Rate = 4%

Beta = 1.3

Market Return = 10%

Cost of Equity = 4% + 1.3 × (10% – 4%) = 4% + 1.3 × 6% = 4% + 7.8% = 11.8%

This means the company needs to deliver at least an 11.8% return to make investing worthwhile for its shareholders.

Example of Cost of Equity

Let’s examine a more detailed example using CAPM for a US tech company:

Suppose a company like ABC Technologies is listed on the Nasdaq. Analysts have estimated the following:

The US 10-year Treasury yield (risk-free rate) is 4.2%

ABC has a beta of 1.1

The expected return on the US market is 9.5%

Using the CAPM formula:

Cost of Equity = 4.2% + 1.1 × (9.5% – 4.2%)

= 4.2% + 1.1 × 5.3%

= 4.2% + 5.83%

= 10.03%

So, ABC must earn returns above 10.03% to satisfy its shareholders.

Frequently Asked Questions

How Cost of Equity Affects Investment and Capital Structure Decisions

The cost of equity acts as a benchmark return for evaluating potential projects. A company will usually only invest in projects expected to generate returns above the cost of equity.

In terms of capital structure, companies compare the cost of equity to the cost of debt. Since equity is generally more expensive (because of its higher risk), companies try to find a balance that minimises their overall cost of capital.

What Factors Influence a Company’s Cost of Equity?

Several variables affect a firm’s cost of equity, including:

Interest Rates: As the risk-free rate changes, so does the cost of equity.

Market Volatility: Higher uncertainty increases expected returns.

Company Beta: A high beta suggests more risk, leading to a higher cost of equity.

Company-Specific Risk: Factors like profitability, growth, and debt levels also play a role.

How Does Cost of Equity Differ from Cost of Debt?

The cost of equity is what shareholders expect in return, while the cost of debt is the interest paid on borrowed funds. Debt is often cheaper because:

Interest is tax-deductible

Lenders have priority over shareholders in case of liquidation

However, equity doesn’t require repayment, making it less risky from a liquidity perspective.

Why is the Cost of Equity Important in Capital Budgeting?

In capital budgeting, the cost of equity serves as the discount rate used to calculate the Net Present Value (NPV) of a project. If the NPV is positive (i.e. the return exceeds the cost of equity), the project adds value. If not, it’s best avoided.

This ensures that companies allocate capital efficiently and protect shareholder interests.

Can a Company’s Cost of Equity Change Over Time?

Yes, and quite frequently. Factors that may cause changes include: