What Is the Cost of Equity Formula? And How to Apply It
By Indeed Editorial Team
Published 2 June 2022
The Indeed Editorial Team comprises a diverse and talented team of writers, researchers and subject matter experts equipped with Indeed's data and insights to deliver useful tips to help guide your career journey.
The cost of equity is the return an investor requires for investing in a company or the rate of return required by a company to invest in a project. It's usually analysed by a company's accountant to assess whether an investment is worth the associated risks. If you're interested in becoming an accountant, it's essential to learn about the cost of equity and how to calculate it. In this article, we define the cost of equity formula, explain how to calculate it and compare it to other common metrics.
What is the cost of equity formula?
The cost of equity formula is the methodology used to calculate a company's level of return, which is provided in exchange for an investment of capital. To properly compute the cost of equity, it's important to understand these key terms:
The required rate of return: This is the minimum rate of return an investor is seeking on an investment.
The dividend yield: This is the annual dividend paid by a company divided by its current share price.
The expected growth rate: The rate at which a company expects its earnings to grow in the future.
Calculating the cost of equity
There are two main formulas for calculating the cost of equity, the dividend capitalisation model and the capital asset pricing model (CAPM). Here's an overview of each:
The dividend capitalisation model
The dividend capitalisation model uses dividends per share for the next year, divided by the current market value of a company's shares and adds this to the growth rate of dividends. This formula is used to calculate the cost of equity for a company that pays dividends. The formula is:
Cost of Equity = (Dividends per share / Current market value) + Growth rate of dividends
Example: Umberland Co. is going to pay a dividend of $45 next year. The current market value per Umberland share is $150. The expected growth in dividends is 5% or (.05). Umberland's cost of equity is:
Cost of equity = (Dividends per share / Current market value) + Growth rate of dividends
Cost of equity = (45 / 150) + 0.05 = 0.35
This means Umberland's cost of equity is 35% of its current market value.
The CAPM formula
The CAPM formula accounts for the riskiness of an investment relative to the market volatility. Here's the CAPM formula:
Cost of equity = Risk-free rate + Equity risk premium
The equity risk premium is obtained from the market risk premium and the beta coefficient of a stock. The formula for calculating equity risk premium is
Equity risk premium = Beta coefficient × (Market return - Risk-free rate)
The risk-free rate is the return rate from a risk-free investment, such as a government treasury bond. The beta coefficient is the statistic you use to measure the systematic risk or volatility of an asset relative to the market. You can calculate this through regression by dividing the covariance of an asset and the market's returns by the variance of the market. You can also derive a beta coefficient by referencing already calculated betas of companies similar to the one you're analysing. Market return refers to the average return of the market over a given period.
Example: The yield on five-year treasury bonds as of 30 April is 0.63% and Butterfly Inc.'s share price as of 30 April is $256.94 per share. Butterfly Inc. has a beta coefficient of 1.74. The twelve-month market return as of 30 April is 10.33%. Butterfly Inc.'s cost of equity is:
Cost of Equity = 0.63 + 1.74 x (10.33 - 0.63) = 0.175
Other methods of calculating the cost of equity
Other methods of calculating the cost of equity are:
Bond yield plus risk premium model
The bond yield plus risk premium model is based on the notion that return on equity is higher than payments required from debt, this is because equity tends to hold greater risk than debt. This formula calculates the after-tax cost of debt and adds a risk premium to account for the rise in risk. The bond yield plus risk premium formula is:
Cost of equity = After-tax cost of debt + Risk Premium
A company's after-tax cost of debt is the effective interest rate that a company is paying for its debts after considering taxes. You can calculate a company's effective interest rate by dividing all of its interest payments by its total debts. The risk premium is the difference between an estimated rate of return of a company and the risk-free rate. The formula for calculating the after-tax cost of debt is:
After-tax cost of debt = Effective interest rate x (1 - tax rate)
Un-levered cost of equity
Un-levered cost of equity is the cost of equity using the assumption that a company doesn't have debt attached to its capital. It's calculated using the capital asset pricing model, but you substitute the equity beta coefficient with an un-levered beta. The formula for un-levered cost of equity is:
Un-levered cost of equity = Risk-free rate + Unlevered beta x Market risk premium
An unlevered beta is when you remove the effects of debt from a beta. You can calculate an unlevered beta using this formula:
Unlevered beta = Beta coefficient / (1 + (1 - tax rate) x (Debt / Equity))
Importance of the cost of equity
The cost of equity is an important metric for businesses because it helps measure the opportunity cost of investing in certain projects or ventures. It tells a company whether the expected return on investment is worth the risk. This information is essential for businesses to make more informed financial decisions and avoid unnecessary investment risks. Cost of equity is a crucial benchmark in assessing the profitability of investment proposals, determining whether profit margins are viable and can increase a company's value and help to assess whether management is increasing shareholder value.
Cost of equity vs. cost of capital
Cost of capital refers to the amount a company pays to raise more funds for the business. In contrast to the cost of equity, the cost of capital actually encompasses the cost of equity and the cost of debt. Equity and debt investors generally require a return on their investment through either capital gains or interest payments. Publicly listed companies may raise capital by selling shares or taking out loans. Companies with strong finances typically keep their costs of capital and equity low, so they can keep their capital repayments lower and more stable.
Cost of equity vs. cost of debt
The cost of debt is the interest rate a company pays on its debts incurred from loans. Cost of debt may refer to the amount a company owes before or after considering tax. For low-risk companies, interest payments on debt are usually lower and have a longer term, as creditors have confidence in their stability. For high-risk companies, creditors may charge higher interest rates with a short repayment period to compensate for the higher risks. Cost of equity refers to payments provided for and returned to shareholders, while the cost of debt is referring to payments made to a company's creditors.
Cost of equity vs. cost of retained earnings
The retained earnings of a company are the previous or historical profits of a company without dividend payments. It's the remaining net income of a company after already paying dividends. Retained earnings often fluctuate depending on the financial performance of a company in a given period. A company's retained earnings increases when a company generates profit and decreases when it records a loss.
Retained earnings are what a company reserves for operational and investment expenses instead of paying shareholders through dividends. Many companies retain earnings to ensure they have adequate future resources to fund their operations and for expansion purposes. The cost of retained earnings represents the potential returns of an investor if a company had paid the retained earnings through dividends.
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