Cost of Equity Formula

What is the Cost of Equity?

The cost of equity is the rate of return for a company’s equity investors. The rate of “return” and “risk” go hand-in-hand as equity investors will require a level of return that is proportional to the amount of risk they are taking on. 

Equity investors considering buying shares of a risky company will demand a higher rate of return to compensate for higher levels of risk (think of a startup tech company with no profits but high growth potential). On the other hand, equity investors will settle with less return for lower-risk companies (think large Fortune 500 companies with consistent year-over-year profits).

When to use the Cost of Equity?

The cost of equity is a key component of calculating a company’s cost of capital. This is typically done through WACC (Weighted Average Cost of Capital) where this calculation takes the weighted average of a company’s cost of debt and cost of equity.

Figuring out a company’s cost of capital is extremely useful as it can be used as a discount rate in a DCF (Discounted Cash Flow) and other financial models.

A company’s cost of capital can also be used to evaluate new business projects and opportunities. The big idea here is that if a new project can generate income at a rate that is greater than the company’s cost of capital then the company should proceed with the project.

Note: Unlike the cost of debt which covers a tangible business expense (interest expense), the cost of equity is very difficult to measure. Current practice estimates the cost of equity using the company’s stock price which as you can imagine will have a number of different immeasurable variables.

Calculating the Cost of Equity

The cost of equity is commonly calculated with CAPM (Capital Asset Pricing Model). This formula essentially estimates the equity returns of a stock based on the market returns and the company’s correlation to the market.

CAPM - Capital Asset Pricing Model

Cost of Equity = R_f + B(R_m - R_f)

Formula Inputs

• R_f = Risk-free rate. Typically represented by the 10-year U.S. treasury yield
• B = Beta. The volatility of a company’s stock price relative to the overall market.
• R_m = Expected market return. The expected return of the market. Typically, use some sort of long-term average that sits between 7-10% annual return.

Risk-Free Rate R_f

The risk-free rate serves as the base rate in the CAPM formula. The idea here is that all companies have some sort of inherent risk which suggests that the expected return (or risk) should be X amount above the risk-free rate.

So why do we use the U.S. government treasury yield (rate) as our risk-free rate? The theory here is that the U.S. government is the closest thing you can get to a risk-free investment as the U.S. government has never defaulted on its debt.

Beta B

Beta is a figure that measures a company’s volatility (movement in share price) relative to the overall market volatility.

• B > 1: When beta is greater than one, the company’s share price is more volatile than the market. (Ex. market goes up 5% and the company goes up 10%).
• B = 1: When beta is equal to 1, the company’s share price is in line with the market. (Ex. market goes up 5% and the company goes up 5%).
• B < 1: When beta is equal to 1, the company’s share price is less volatile than the market. (Ex. market goes up 5% and the company goes up 3%).
• B < 0: When beta is less than 1, the company’s share price is inversely related to the market. (Ex. market goes up 5%, the company goes down 5%).

The technical method of calculating beta takes the covariance of the company and market returns and divides that figure by the variance of the market returns.

Beta Calculation: Covariance (Company Returns, Market Returns) / Variance (Market Returns).

Alternatively, you can also pull up estimate company Beta’s figures on Bloomberg, Yahoo Finance, MarketWatch, etc. Some financial analysts may also calculate a company’s Beta by taking the median Beta from a group of comparable companies. If you do try the comparable companies method, make sure you understand the difference between unlevered and levered beta.

Expected Market Return R_m

We need to understand the expected return of the market to be able to use Beta to find the expected returns on your target company. For U.S. companies, financial analysts will typically use the long-term annualized returns of the S&P 500 which typically fall between 7-10%.

You’ll notice that the CAPM formula subtracts the risk-free rate from the expected return on the market. This is sometimes referred to as the “market risk premium” which really represents the additional returns of the market above the risk-free rate.

Additional Resources

Awesome! Now you know how to calculate a company’s cost of equity (really the hard part of calculating WACC).

If you’re interested in further developing your technical finance skills, we encourage you to check out our Complete Finance & Valuation Course where we cover how to make built-from-scratch DCF models, precedent transactions models, comparable companies models, and more!

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