What Is the Cost of Equity?

The cost of equity is the return that a company requires to decide if an investment meets capital return requirements. Firms often use it as a capital budgeting threshold for the required rate of return. A firm’s cost of equity represents the compensation that the market demands in exchange for owning the asset and bearing the risk of ownership. The traditional formula for the cost of equity is the dividend capitalization model and the capital asset pricing model (CAPM).

Cost of Equity Formula

Using the dividend capitalization model, the cost of equity is:

$\begin{aligned}&\text{Cost of Equity}=\frac{\text{DPS}}{\text{CMV}}+\text{GRD}\\&\textbf{where:}\\&\text{DPS}=\text{Dividends per share, for next year}\\&\text{CMV}=\text{Current market value of stock}\\&\text{GRD}=\text{Growth rate of dividends}\end{aligned}$​Cost of Equity=CMVDPS​+GRDwhere:DPS=Dividends ;per share, for next yearCMV=Current market value of stockGRD=Growth rate of dividends​

What the Cost of Equity Can Tell You

The cost of equity refers to two separate concepts, depending on the party involved. If you are the investor, the cost of equity is the rate of return required on an investment in equity. If you are the company, the cost of equity determines the required rate of return on a particular project or investment.

There are two ways that a company can raise capital: debt or equity. Debt is cheaper, but the company must pay it back. Equity does not need to be repaid, but it generally costs more than debt capital due to the tax advantages of interest payments. Since the cost of equity is higher than debt, it generally provides a higher rate of return.

Special Considerations

The dividend capitalization model can be used to calculate the cost of equity, but it requires that a company pays dividends. The calculation is based on future dividends. The theory behind the equation is that the company’s obligation to pay dividends is the cost of paying shareholders and therefore the cost of equity. This is a limited model in its interpretation of costs.

The capital asset pricing model, however, can be used on any stock, even if the company does not pay dividends. That said, the theory behind CAPM is more complicated. The theory suggests that the cost of equity is based on the stock’s volatility and level of risk compared to the general market.

The CAPM Formula is:

$\begin{aligned}&\text{CoE}=\text{RFRR}\\&\qquad\quad+\text{B}\times\text{(MRR}-\text{RFRR)}\\&\textbf{where:}\\&\text{CoE}=\text{Cost of Equity}\\&\text{RFRR}=\text{Risk-free rate of return}\\&\text{B}=\text{Beta}\\&\text{MRR}=\text{Market rate of return}\end{aligned}$​CoE=RFRR+B×(MRR−RFRR)where:CoE=Cost of EquityRFRR=Risk-free rate of returnB=BetaMRR=Market rate of return​

In this equation, the risk-free rate is the rate of return paid on risk-free investments such as Treasuries. Beta is a measure of risk calculated as a regression on the company’s stock price. The higher the volatility, the higher the beta and relative risk compared to the general market.

The market rate of return is the average market rate. In general, a company with a high beta—that is, a company with a high degree of risk—will have a higher cost of equity.

Cost of Equity vs. Cost of Capital

The cost of capital is the total cost of raising capital, taking into account both the cost of equity and the cost of debt. A stable, well-performing company generally will have a lower cost of capital. To calculate the cost of capital, the cost of equity and the cost of debt must be weighted and then added together. The cost of capital is generally calculated using the weighted average cost of capital.

When considering the weighted average cost of capital, companies may favor the financial option that is least expensive. For example, its cost of equity may be 8% while its cost of debt may be 4%. Assuming a company has a balanced capital structure (50% of each), the company's total cost of capital is 6%.

As a company goes out to seek additional capital, it often compares which method is cheaper than its weighted average cost of capital. In this case, the company's average debt costs less, so the company may be opposed to issuing additional equity at a higher cost.

The Bottom Line

A company's cost of equity is an important consideration as companies determine the best way to raise capital. Often calculated as the dividends issued per share divided by the current market price (plus a growth rate), the cost of equity is the expense a company should assume it must return back to investors based on prevailing costs. The cost of equity is often compared to the cost of debt when making capital structure decisions.