What is Cost of Equity?
Cost of equity refers to a shareholder's required rate of return on an equity investment. It is the rate of return that could have been earned by putting the same money into a different investment with equal risk.
How Does Cost of Equity Work?
In general, there are two ways to determine cost of equity.
First is the dividend growth model:
Cost of Equity = (Next year's Annual Dividend / Current Stock Price) + Dividend Growth Rate
Second is the Capital Asset Pricing Model (CAPM):
ra = rf + Ba (rm-rf)
Let's assume the following for Company XYZ:
Next year's dividend: $1
Current stock price: $10
Dividend growth rate: 3%
Using the dividend growth model, we can calculate that Company XYZ's cost of capital is ($1 / $10 ) + 3% = 13%
Using CAPM, we can calculate that Company XYZ's cost of capital is 3% + 1.0*(12% - 3%) = 12%
Why Does Cost of Equity Matter?
Cost of equity is a key component of stock valuation. Because an investor expects his or her equity investment to grow by at least the cost of equity, cost of equity can be used as the discount rate used to calculate an equity investment's fair value.
Both cost of equity calculation methods have advantages and disadvantages.
The dividend growth model is simple and straightforward, but it does not apply to companies that don't pay dividends, and it assumes that dividends grow at a constant rate over time. The dividend growth model also quite sensitive to changes in the dividend growth rate, and it does not explicitly consider the risk of the investment.
CAPM is useful because it explicitly accounts for an investment's riskiness and can be applied by any company, regardless of its dividend size or dividend growth rate. However, the components of CAPM are estimates, and they generally lead to a less concrete answer than the dividend growth model does. The CAPM method also implicitly relies on past performance to predict the future.
If you'd like to read more in-depth information about how to calculate and use cost of equity, check out these related definitions: