The cost of equity is the return that an investor expects to receive from an investment in a business. This cost represents the amount the market expects as compensation in exchange for owning the stock of the business. One way to derive the cost of equity is the dividend capitalization model, which bases the cost of equity primarily on the dividends issued by a company. The formula is:
(Dividends per share for next year ÷ Current market value of the stock) + Dividend growth rate
For example, the expected dividend to be paid out next year by ABC Corporation is $2.00 per share. The current market value of the stock is $20. The historical growth rate for the dividend payments has been 2%. Based on this information, the company's cost of equity is calculated as follows:
($2.00 Dividend ÷ $20 Current market value) + 2% Dividend growth rate
= 12% Cost of equity
When a business does not pay out dividends, this information is estimated based on the cash flows of the organization and a comparison to other firms of the same size and operating characteristics.
A different way to calculate the cost of equity is to view it as the stock price that must be maintained in order to keep investors from selling the stock. Under this approach, the cost of equity formula is composed of three types of return: a risk-free return, an average rate of return to be expected from a typical broad-based group of stocks, and a differential return that is based on the risk of the specific stock in comparison to the larger group of stocks.
The risk-free rate of return is derived from the return on a U.S. government security. The average rate of return can be derived from any large cluster of stocks, such as the Standard & Poor’s 500 or the Dow Jones Industrials. The return related to risk is called a stock’s beta; it is regularly calculated and published by several investment services for publicly-held companies, such as Value Line. A beta value of less than one indicates a level of rate-of-return risk that is lower than average, while a beta greater than one would indicate an increasing degree of risk in the rate of return. Given these components, the formula for the cost of common stock is as follows:
Risk-Free Return + (Beta x (Average Stock Return – Risk-Free Return))
For example, the risk-free rate of return of the Purple Widget Company is 5%, the return on the Dow Jones Industrials is 12%, and the company’s beta is 1.5. The cost of equity calculation is:
5% Risk-Free Return + (1.5 Beta x (12% Average Return – 5% Risk-Free Return) = 15.5%