What is the Cost of Equity Capital Formula?

Cost of equity (Ke)Cost Of Equity (Ke)Cost of equity is the percentage of returns payable by the company to its equity shareholders on their holdings. It is a parameter for the investors to decide whether an investment is rewarding or not; else, they may shift to other opportunities with higher returns.read more is what shareholders expect to invest their equity into the firm. One can calculate the cost of the equity formula below:

  • Method 1 – Cost of Equity Formula for Dividend CompaniesMethod 2 – Cost of Equity Formula using CAPM ModelCAPM ModelThe Capital Asset Pricing Model (CAPM) defines the expected return from a portfolio of various securities with varying degrees of risk. It also considers the volatility of a particular security in relation to the market.read more

We will discuss each of the methods in detail.

Method #1 – Cost of Equity Formula for Dividend Companies

Where,

  • DPS = Dividend Per ShareDividend Per ShareDividends per share are calculated by dividing the total amount of dividends paid out by the company over a year by the total number of average shares held.read moreMPS = Market Price per Sharer = Growth rate of Dividends

The dividend growth modelDividend Growth ModelThe Dividend Discount Model (DDM) is a method of calculating the stock price based on the likely dividends that will be paid and discounting them at the expected yearly rate. In other words, it is used to value stocks based on the future dividends’ net present value.read more requires that a company pays dividends. Therefore, it is based on upcoming dividends. The logic behind the equation is that the company’s obligation to pay dividends is the cost of producing its shareholders. Therefore, the Ke, i.e., cost of equity. It is a limited model in its interpretation of costs.

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Cost of Equity Calculations

You can consider the following example for a better understanding of the Cost of Equity Formula:

Example #1

Let us try the cost of equity calculation with a first formula where we assume a company is paying regular dividends.

Suppose XYZ Co. is a regularly paying dividend company. Its stock price is currently trading at 20, and it expects to pay a dividend of 3.20 next year. The following is the dividend payment history. So, now, let us calculate the company’s cost of equity.

Solution:

Let us first calculate the average growth rate of dividends. Then, continuing the same formula as per below will yield yearly growth rates.

So the growth rate for all the years will be-

Take a simple average growth rate, which will come to 1.31%.

Now we have all the inputs i.e.

DPS for next year = 3.20, MPS = 20 and r = 1.31%

Hence

  • Cost of Equity Formula= (3.20/20) + 1.31%Cost of Equity Formula= 17.31%Hence, the cost of equity for XYZ company will be 17.31%.

Example #2 – Infosys

Below is the company’s dividend history, ignoring interim and any special dividendSpecial DividendThe term “Special Dividend” refers to an amount distributed to shareholders in the name of a dividend that is in addition to the regular dividend. Companies do this in the event of an unexpected inflow of cash or assets.read more for the time being.

The Share price of Infosys is 678.95 (BSE). Its average dividend growthDividend GrowthDividend Growth is defined as a significant rise in a company’s dividend payout to its shareholders from one period of time to another in comparison to the dividend payout of the previous period of time (generally the growth is calculated on yearly basis).read more rate is 6.90%, computed from the above table. It paid its last dividend of 20.50 per share.

Therefore,

  • Cost of Equity Formula = {[20.50(1+6.90%)]/678.95} +6.90%Cost of Equity Formula = 10.13%

Method #2 – Cost of Equity Formula using CAPM Model

Below is the cost of equity formula using the Capital Asset Pricing ModelCapital Asset Pricing ModelThe Capital Asset Pricing Model (CAPM) defines the expected return from a portfolio of various securities with varying degrees of risk. It also considers the volatility of a particular security in relation to the market.read more.

  • R(f) = Risk-Free Rate of Returnβ = Beta of the stockE(m) = Market Rate of Return[E(m)-R(f)] = equity risk premium

However, the Capital Asset Pricing Model (CAPM) can be used on several stocks, even if they are not paying dividends. With that said, the logic behind CAPM is rather complicated, which suggests the cost of equity (Ke) is based on the stock’s volatility, which is computed by beta and level of risk compared to the general market, i.e., the equity market risk premiumMarket Risk PremiumThe market risk premium is the supplementary return on the portfolio because of the additional risk involved in the portfolio; essentially, the market risk premium is the premium return investors should have to make sure to invest in stock instead of risk-free securities.read more which is nothing but a differential of Market Return and Risk-Free Rate.

In the CAPM equation, the risk-free rate (Rf)The Risk-free Rate (Rf)A risk-free rate is the minimum rate of return expected on investment with zero risks by the investor. It is the government bonds of well-developed countries, either US treasury bonds or German government bonds. Although, it does not exist because every investment has a certain amount of risk.read more is the rate of return paid on risk-free investments like government bonds or treasuries. Beta, a measure of risk, can be calculated as a regression on the company’s market price. The higher the volatility, the higher the beta will come and its relative risk compared to the general stock market. The market rate of return Em(r) is the average market rate, which has generally been assumed to be 11% to12 % over the past eighty years. A company with a high beta will have a high risk and pay more for equity.

Below, the three companies’ inputs have arrived. Now we have to calculate their cost of equity.

First, we will calculate the equity risk premiumThe Equity Risk PremiumEquity Risk Premium is the expectation of an investor other than the risk-free rate of return. This additional return is over and above the risk free return.read more, which is the difference between market return and risk-free return rate, i.e.,

Then, we will calculate the cost of equity using CAPM, i.e., 

Rf + β [E(m) – R(f)] i.e., Risk-free rate + Beta(Equity Risk Premium)

Continuing the same formula above for all the companies, we will get the cost of equity.

So, the cost of equity for companies X, Y, and Z comes to 7.44%, 6.93%, and 8.20%, respectively.

Example #2 – TCS Cost of Equity using the CAPM Model

Let us try calculating the cost of equity for TCS through the CAPM model. 

For the time being, we will take the 10-year government bond yield at a risk-free rate of 7.46%. 

Source: https://countryeconomy.com

Secondly, we need to come up with an Equity Risk Premium,

Source: http://pages.stern.nyu.edu/

For India, the Equity Risk Premium is 7.27%.

We need a beta for TCS, which we have taken from Yahoo finance India.

Source: https://in.finance.yahoo.com/

So the cost of equity (Ke) for TCS will be-

  • Cost of Equity Formula = Rf + β [E(m) – R(f)]Cost of Equity Formula= 7.46% + 1.13 * (7.27%)Cost of Equity Formula= 15.68%

You can use the following cost of equity formula calculator.

Relevance and Use

  • A firm uses a cost of equity (Ke) to assess the relative attractiveness of its opportunities in the form of investments, including external projects and internal acquisitions. Companies will typically use a combination of debt and equity financing, with equity capital proving to be more expensive.Investors willing to invest in stock also use a cost of equity to find whether the company is earning a rate of return greater than it, less than it, or equal to that rate.Equity Analyst, Research Analyst Research AnalystResearch analyst is a profession where the main task includes research on specific fields, analyzing the facts and figures, interpreting the analysis, and finally presenting the same to a structured audience that can relate to marketing, finance, operations.read more, buy or sell-side analyst, etc., who are majorly involved in financing modeling and issuing research reports, uses the cost of equity to arrive at the valuation of the companies they follow. Then, advise whether the stock is over or undervalued and then make an investment decision.Many other methods are also used to compute the cost of equity, which are running a regression analysis, multi-factor modelMulti-factor ModelFactor Models are financial models that incorporate factors (macroeconomic, fundamental, and statistical) to determine the market equilibrium and calculate the required rate of return. They associate the return of a security to single or multiple risk factors in a linear model.read more, survey method, etc.

Cost of Equity Formula in Excel (with Excel template)

Let us take the case mentioned in the above cost of equity formula example no.1 to illustrate the same in the Excel template below.

Suppose XYZ Co. is a regularly paying dividend company. Its stock price is currently trading at 20. It expects to pay a dividend of 3.20 next year. The following is the dividend payment history.

In the below-given table is the data for calculating the cost of equity. 

In the below given Excel template, we have used the cost of equity equation calculation to find the cost of equity.

So the calculation of the cost of equity will be-

Cost of Equity Formula Video

This article is a guide to the Cost of Equity Formula. Here, we learn two methods of calculation of the cost of equity with examples. You may learn more about valuations from the following articles: – 

  • Equity FormulaEquity FormulaEquity is the amount of money left for the shareholders or owners to rightfully claim after all the liabilities & debts are paid off. This is determined by deducting a company’s total liabilities from its total assets for a given period. read moreWhat is Equity Financing?What Is Equity Financing?Equity financing is the process of the sale of an ownership interest to various investors to raise funds for business objectives. The money raised from the market does not have to be repaid, unlike debt financing which has a definite repayment schedule.read moreBeta CoefficientBeta CoefficientThe beta coefficient reflects the change in the price of a security in relation to the movement in the market price. The Beta of the stock/security is also used for measuring the systematic risks associated with the specific investment.read more