Cost of Equity

The cost of equity is the return required by investors for holding a company’s equity. For a business, it represents the minimum return a project or investment must deliver to justify financing with equity. Companies use it in capital budgeting and capital-structure decisions; investors use it as a benchmark to judge whether an equity investment compensates for its risk.

Key points

• It is the required rate of return for equity investors (or the rate a firm must achieve on projects financed by equity).
• Two common estimation methods: the dividend capitalization (Gordon growth) model and the Capital Asset Pricing Model (CAPM).
• The cost of equity is typically higher than the cost of debt because equity investors bear greater risk and interest on debt is tax-deductible.
• The weighted average cost of capital (WACC) combines the cost of debt and cost of equity according to the firm’s capital structure.

How it works

A company raises capital via debt or equity. Debt often costs less because interest is tax-deductible and debt holders have senior claims, but it must be repaid. Equity does not need to be repaid, but investors demand higher returns for taking on greater risk and residual claim. Firms compare the cost of equity with alternatives (e.g., debt) when deciding how to finance growth or which projects to pursue.

Formulas

Dividend capitalization (Gordon growth) model

When a firm pays steady and growing dividends:
Cost of Equity = DPS1 / P0 + g

Where:
* DPS1 = dividends per share expected next year
P0 = current market price per share
g = expected constant growth rate of dividends

Example: If expected next-year dividends = $2.00, current price = $50, and dividend growth = 4%:
Cost of Equity = 2 / 50 + 0.04 = 0.04 + 0.04 = 8.0%

Limitations: requires dividends and assumes constant growth.

Capital Asset Pricing Model (CAPM)

Useful for dividend and non-dividend-paying stocks:
CoE = Rf + β × (Rm − Rf)

Where:
* Rf = risk-free rate (e.g., Treasury yield)
β = beta, a measure of the stock’s volatility relative to the market
Rm = expected market return
* (Rm − Rf) = market risk premium

Example: If Rf = 1%, Rm = 10%, and β = 1.1:
CoE = 1% + 1.1 × (10% − 1%) = 1% + 1.1 × 9% = 10.9%

Limitations: relies on estimated inputs (beta, market return) and assumes a single-factor risk model.

Special considerations and practical issues

• Choosing the risk-free rate: typically a long-term government bond yield, but maturity should match the investment horizon.
• Estimating beta: historical regression estimates can be noisy; betas vary over time and across data sources.
• Estimating market return and growth: long-run averages are commonly used, but forecasts differ.
• Dividend model applicability: only for firms with predictable dividend policies and steady growth rates.
• CAPM assumptions: market efficiency, a representative market portfolio, and that beta fully captures systematic risk—these can be imperfect in practice.
• Adjustments: analysts sometimes add size premiums, country risk premiums, or use multi-factor models when CAPM looks insufficient.

Cost of Equity vs. Cost of Capital (WACC)

WACC combines the after-tax cost of debt and the cost of equity, weighted by their proportions in the firm’s capital structure:
WACC = (E / (D+E)) × Re + (D / (D+E)) × Rd × (1 − Tc)

Where:
* Re = cost of equity
Rd = cost of debt
E, D = market values of equity and debt
* Tc = corporate tax rate

Example (simplified, ignoring taxes): if Re = 8%, Rd = 4%, and the firm is 50% equity / 50% debt, WACC ≈ 6%.

Firms compare prospective financing alternatives against WACC to decide whether new investments will create value.

Practical uses

• Investors: compare expected returns to the required return (cost of equity) to decide whether to buy or hold a stock.
• Companies: use cost of equity in project appraisal and to determine whether to raise funds via equity or debt.
• Valuation: inputs to discounted cash flow (DCF) models and to compute WACC for firm valuation.

Quick FAQ

Q: Which method should I use—dividends or CAPM?
A: Use the dividend model for stable, dividend-paying firms with predictable growth. Use CAPM for firms without dividends or when you prefer a market-risk-based approach.

Q: Is cost of equity always higher than cost of debt?
A: Generally yes, because equity investors bear greater risk and interest expense on debt provides a tax shield.

Q: Can estimates change rapidly?
A: Yes—changes in interest rates, market expectations, or stock volatility will change cost-of-equity estimates.

Bottom line

The cost of equity is a key input for investment decisions and valuation. Choose the estimation method that best fits the firm’s characteristics, be careful with input assumptions, and compare the cost of equity with the cost of debt to guide financing and project-selection choices.