Cost of Equity

Compensating shareholders for waiting for their returns and for bearing risk. Explanation of Cost of Equity.

What is Cost of Equity? Description

Cost of Equity is a financial term that is used to indicate the minimum annual Rate of Return a firm must offer to its ordinary shareholders for waiting for their returns and for bearing risk. The risk consists of both the market risk and the company-specific risk. Therefore it will vary from company to company.

The cost of equity reflects the opportunity cost of investing for the shareholders. The compensation that the shareholders receive typically consists of:

Dividend
Capital gains (through increases in the share price)

Note that the returns are expected future returns, not historical returns. Therefore they can be expressed as the anticipated dividends on the shares in each year in perpetuity. The cost of equity is then the current market price of the share plus the discounted value of all future dividends in perpetuity.

The Cost of Equity is just one of the components of the (total) Cost of Capital for any company. Another main source of financing is Debt (using company bonds), for which the Cost of Debt can be calculated. See also WACC.

Calculation of the Cost of Equity. Formula

The Cost of Equity can be calculated by dividing the Dividends per Share for Next Year by the Current Market Value of the Stock, and then adding the Growth Rate of the Dividends (see figure). Another way to calculate it, is by taking a Risk-free Return (the return of a government bond) and adding to that the company's Beta (as published frequently by certain investment services companies) times the difference of an Average Stock Return (for example the average return of all stocks in the Dow Jones) minus the Risk-free Return (see figure).

Usage of Cost of Equity. Example

Suppose an investor requires a rate of return of 9% on an investment in ABC Bank, because of the bank's risk profile. The stock is currently trading for € 100 and is expected to pay a dividend of € 3. For each share, the investor will want a € 9 return in total, which is composed of the € 3 of the dividend plus a € 6 increase in share price. The Cost of Equity for ABC Bank are 9%.