Cost of Equity Shares18/05/2020
Cost of Equity is the rate of return a company pays out to equity investors. A firm uses cost of equity to assess the relative attractiveness of investments, including both internal projects and external acquisition opportunities. Companies typically use a combination of equity and debt financing, with equity capital being more expensive.
The cost of equity can be calculated by using the CAPM (Capital Asset Pricing Model) or Dividend Capitalization Model (for companies that pay out dividends).
CAPM (Capital Asset Pricing Model)
CAPM takes into account the riskiness of an investment relative to the market. The model is less exact due to the estimates made in the calculation (because it uses historical information).
E(Ri) = Rf + βi * [E(Rm) – Rf]
E(Ri) = Expected return on asset i
Rf = Risk-free rate of return
βi = Beta of asset i
E(Rm) = Expected market return
Risk-Free Rate of Return
The return expected from a risk-free investment (if computing the expected return for a US company, the 10-year Treasury note could be used).
The measure of systematic risk (the volatility) of the asset relative to the market. Beta can be found online or calculated by using regression: dividing the covariance of the asset and market’s returns by the variance of the market.
βi < 1: Asset i is less volatile (relative to the market)
βi = 1: Asset i’s volatility is the same rate as the market
βi > 1: Asset i is more volatile (relative to the market)
Expected Market Return
This value is typically the average return of the market (which the underlying security is a part of) over a specified period of time (five to ten years is an appropriate range)
Dividend Capitalization Model
The Dividend Capitalization Model only applies to companies that pay dividends, and it also assumes that the dividends will grow at a constant rate. The model does not account for investment risk to the extent that CAPM does (since CAPM requires beta).
Dividend Capitalization Formula:
Re = (D1 / P0) + g
Re = Cost of Equity
D1 = Dividends/share next year
P0 = Current share price
g = Dividend growth rate
Dividends/Share Next Year
Companies usually announce dividends far in advance of the distribution. The information can be found in company filings (annual and quarterly reports or through press releases). If the information cannot be located, an assumption can be made (using historical information to dictate whether the next year’s dividend will be similar).
Current Share Price
The share price of a company can be found by searching the ticker or company name on the exchange that the stock is being traded on, or by simply using a credible search engine.
Dividend Growth Rate
The Dividend Growth Rate can be obtained by calculating the growth (each year) of the company’s past dividends and then taking the average of the values.
The growth rate for each year can be found by using the following equation:
Dividend Growth = (Dt/Dt-1) – 1
Dt = Dividend payment of year t
Dt-1 = Dividend payment of year t-1 (one year before year t)