It is one of the most significant attributes that you need to look at before investing in the company’s shares. Let us look at the graph above. The Cost for Yandex is 18.70%, while that of Facebook is 6.30%. What does this mean? How would you calculate it? What metrics do you need to be aware of while looking at Ke?

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We will look at all of it in this article.

What is the Cost of Equity?

The cost of equity is the rate of return the investor requires from the stock before looking into other viable opportunities.

If we can go back and look at the concept of “opportunity cost,” we will understand it better. Suppose you have US $1000 to invest! So you look for many opportunities. And you choose the one which, according to you, would yield more returns. As you decided to invest in one particular opportunity, you would let go of others, maybe more profitable opportunities. That loss of other alternatives is called “opportunity cost.”

Let’s come back to the Ke. If you, as an investor, don’t get better returns from company A, you will go ahead and invest in other companies. And company A has to bear the opportunity cost if they don’t put in the effort to increase the required rate of return (hint – pay the dividendDividendDividends refer to the portion of business earnings paid to the shareholders as gratitude for investing in the company’s equity.read more and put effort so that the share price appreciates).

Let’s take an example to understand this.

Mr. A wants to invest in Company B. As Mr. A is a relatively new investor, he wants a low-risk stock that can yield him a good return. Company B’s current stock price is US $8 per share, and Mr. A expects that the required rate of returnRequired Rate Of ReturnRequired Rate of Return (RRR), also known as Hurdle Rate, is the minimum capital amount or return that an investor expects to receive from an investment. It is determined by, Required Rate of Return = (Expected Dividend Payment/Existing Stock Price) + Dividend Growth Rateread more will be more than 15%. And through the calculation of the cost of equity, he will understand what he will get as a required rate of return. If he gets 15% or more, he will invest in the company; and if not, he will look for other opportunities.

Formula

The cost of equity can be calculated in two ways. First, we will use the usual model, which has been used by the investors repeatedly. And then we would look at the other one.

#1 – Cost of Equity – Dividend Discount Model

So we need to calculate Ke in the following manner –

Cost of Equity = (Dividends per share for next year / Current Market Value of Stock) + Growth rate of dividends

Here, it is calculated by taking dividends per share into account. So here’s an example to understand it better.

Learn more about the Dividend Discount ModelDividend Discount 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

Mr. C wants to invest in Berry Juice Private Limited. Currently, Berry Juice Private Limited has decided to pay US $2 per share as a dividend. The current market value of the stock is US $20. And Mr. C expects that the appreciation in the dividend would be around 4% (a guess based on the previous year’s data). So, the Ke would be 14%.

How would you calculate the growth rate? We need to remember that the growth rate is the estimated one, and we need to calculate it in the following manner –

Growth Rate = (1 – Payout RatioPayout RatioThe payout ratio formula calculates the amount announced as a dividend out of the total earnings (after-tax profits). There are two formulas to calculate the dividend payout ratio using the earning method and the outstanding method. Payout ratio (earning method)= Total dividend paid/Total earning.read more) * Return on Equity

If we are not provided with the Payout Ratio and Return on Equity Ratio, we need to calculate them.

Here’s how to calculate them –

Dividend Payout Ratio = Dividends / Net Income

We can use another ratio to find out dividend pay-out. Here it is –

Alternative Dividend Payout Ratio = 1 – (Retained Earnings / Net Income)

And also the Return on EquityReturn On EquityReturn on Equity (ROE) represents financial performance of a company. It is calculated as the net income divided by the shareholders equity. ROE signifies the efficiency in which the company is using assets to make profit.read more –

Return on Equity = Net Income / Total Equity

In the example section, we will make the practical application of all of these.

#2- Cost of Equity – Capital Asset Pricing Model (CAPM)

CAPMCAPMCAPM Beta is an essential theoretical measure of how a single stock moves with respect to the market. In this method, we determine the cost of equity by summing up the beta and risk premium product with the risk-free rate.read more quantifies the relationship between risk and required return in a well-functioning market.

Here’s the Cost of Equity CAPM formula for your reference.

Cost of Equity = Risk-Free Rate of Return + Beta * (Market Rate of Return – Risk-free Rate of Return)

  • Risk-free Rate of Return – This is the return of a security with no Default risk is a form of risk that measures the likelihood of not fulfilling obligations, such as principal or interest repayment, and is determined mathematically based on prior commitments, financial conditions, market conditions, liquidity position, and current obligations, among other factors.read moredefault riskDefault RiskDefault risk is a form of risk that measures the likelihood of not fulfilling obligations, such as principal or interest repayment, and is determined mathematically based on prior commitments, financial conditions, market conditions, liquidity position, and current obligations, among other factors.read more, no volatility, and a beta of zero. A ten-year government bond is typically taken as a risk-free rateA Risk-free RateA 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 moreBeta is a statistical measure of a company’s stock price variability concerning the stock market overall. So if the company has a high beta, that means the company has more risk, and thus, the company needs to pay more to attract investors. Simply put, that means more Ke.Risk Premium (Market Rate of Return – Risk-Free Rate) – It measures the return that equity investorsEquity InvestorsAn equity investor is that person or entity who contributes a certain sum to public or private companies for a specific period to obtain financial gains in the form of capital appreciation, dividend payouts, stock value appraisal, etc.read more demand over a risk-free rate to compensate them for the volatility/risk of an investment that matches the volatility of the entire market. Risk premium estimates vary from 4.0% to 7.0%

Let’s take an example to understand this. Let’s say the beta of Company M is 1, and the risk-free return is 4%. The market rate of return is 6%. We need to calculate the cost of equity using the CAPM model.

  • Company M has a beta of 1, which means the stock of Company M will increase or decrease as per the tandem of the market. We will understand more of this in the later sectionKe = Risk-Free Rate of Return + Beta * (Market Rate of Return – Risk-free Rate of Return)Ke = 0.04 + 1 * (0.06 – 0.04) = 0.06 = 6%.

Interpretation

The Ke is not exactly what we refer to. It’s the responsibility of the company. The rate the company needs to generate to allure the investors to invest in their stock at the market price.

That’s why the Ke is also referred to as the “required rate of return.”

So let’s say as an investor, you don’t have any idea what the Ke of a company is! What would you do?

First, you need to find out the total equity of the company. If you look at the balance sheet of the company, you would find it easily. Then you need to see whether the company has paid any dividends or not. You can check their cash flow statementCash Flow StatementA Statement of Cash Flow is an accounting document that tracks the incoming and outgoing cash and cash equivalents from a business.read more to be ensured. If they pay a dividend, you need to use the dividend discount model (mentioned above), and if not, you need to go ahead and find out the risk-free rate and calculate the cost of equity under 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 (CAPM). Calculating it under CAPM is a tougher job as you need to find out the beta by doing regression analysisRegression AnalysisRegression analysis depicts how dependent variables will change when one or more independent variables change due to factors, and it is used to analyze the relationship between dependent and independent variables. Y = a + bX + E is the formula.read more.

Let’s have a look at the examples about how to calculate the Ke of a company under both of these models.

Cost of Equity Example

We will take examples from each model and try to understand how things work.

Example # 1

Now, this is the simplest example of a dividend discount model. We know that the dividend per share is US $30, and the market price per share is US $100. We also know the growth percentage.

Let’s calculate the cost of equity.

Ke = (Dividends per share for next year / Current Market Value of Stock) + Growth rate of dividends

So, Ke of Company A is 17%.

Example # 2

MNP Company has the following information –

We need to calculate Ke of MNP Company.

Let’s look at the formula first, and then we will ascertain the cost of equity using a capital asset pricing model.

Ke = Risk-Free Rate of Return + Beta * (Market Rate of Return – Risk-free Rate of Return)

Note: To calculate the beta 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 for a single stock, you need to look at the stock’s closing price every day for a particular period. Also, the closing level of the market benchmark (usually S&P 500) for a similar period and then use excel in running the regression analysis.

Cost of Equity CAPM Example – Starbucks

Let us take an example of Starbucks and calculate the Cost of Equity using the CAPM model.

Cost of Equity CAPM Ke = Rf + (Rm – Rf) x Beta

Here, I have considered a ten-year Treasury Rate as the Risk-free rate. Some analysts also take a 5-year treasury rate as the risk-free rate. Please check with your research analystResearch 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 before taking a call on this.

Most Important – Download Cost of Equity (Ke) Template

Learn to calculate Starbucks Cost of Equity (Ke) in Excel

source – bankrate.com

Each country has a different Equity Risk Premium. Equity Risk Premium primarily denotes the premium expected by the Equity Investor.

For the United States, Equity Risk Premium is 5.69%.

source – stern.nyu.edu

Let us now look at Starbucks Beta Trends over the past few years. The beta of Starbucks has decreased over the past five years. It means that Starbucks stocks are less volatile than the stock market.

We note that the Beta of Starbucks is at 0.794x

source: ycharts

With this, we have all the necessary information to calculate the cost of equity.

Ke = Rf + (Rm – Rf) x Beta

Ke = 2.42% + 5.69% x 0.794

Ke =6.93%

Industry Cost of Equity

Ke can differ across industries. As we saw from the CAPM formula above, Beta is the only variable unique to each of the companies. Beta gives us a numerical measure of how volatile the stock is compared to the stock market. The higher the volatility, the riskier the stock is.

Please note –

  • Risk-Free Rates and Market Premium is the same across sectors.However, Market premium differs from each country.

#1 – Utilities Companies

Let us look at the Ke of Top Utilities Companies. The below table provides us with the Market Cap, Risk-Free Rate, Beta, Market Premium, and Ke data.

Please note that Risk-Free Rate and Market Premium are the same for all the companies. It is the beta that changes.

source:ycharts

  • We note that the Cost of Equity for Utility companies is pretty low. Most of the stocks in this sector have Ke between 3%-5% It is because most companies have a beta of less than 1.0. It implies that these stocks are not very sensitive to the movement of the stock marketsOutliers here are Brookfield Infrastructure and AES, which have the Ke of 8.4% and 9.4%, respectively.

#2 – Steel Sector

Let’s now take the example of the Steel Sector’s cost of equity.

  • We note that the Ke for the steel sector is high. Most companies have Ke over 10%It is because of the higher betas of steel companies. Higher beta implies that steel companies are sensitive to the stock market movements and can be a risky investment. United States Steel has a beta of 2.75 with a cost of Equity of 18.1%Posco has the lowest Ke among these companies at 8.2% and a beta of 1.01.

#3 – Restaurant Sector

Let us now take Ke Example from the Restaurant Sector.

  • Restaurant companies have low Ke. This is because their beta is less than 1.Restaurant Companies seem to be a cohesive group, with Keranging between 3.5% and 6.7%.

#4 – Internet & Content

Examples of Internet and Content Companies include Alphabet, Facebook, Yahoo, etc.

  • Internet and Content companies have varied Costs of Equity. It is because of the diversity in the Beta of the companies.Yandex and Baidu have a very high beta of 2.85 and 1.90, respectively. On the other hand, Companies like Alphabet and Facebook are fairly stable, with Beta of 0.98 and 0.68, respectively.

#5 – Ke – Beverages

Now let us look at Ke examples from Beverage Sector.

  • Beverages are considered to be defensive stocksDefensive StocksA Defensive Stock is a stock that provides steady growth and earnings to the investors in the form of dividends irrespective of the state of the economy as it has a low correlation with the overall stock market/economy and is therefore insulated from changing business cycles.read more, which primarily means that they do not change much with the market and are not prone to the market cycles. This is evident from Beta’s of Beverages Companies that are much lower than 1.Beverage companies have Ke in the range of 3.6% – 6.8%Coca-Cola has a cost of equity of 6.4%, while its competitor PepsiCo has a Ke of 5.5%.

Limitations

There are a couple of limitations we need to consider –

  • Yandex and Baidu have a very high beta of 2.85 and 1.90, respectively. On the other hand, Companies like Alphabet and Facebook are fairly stable, with Beta of 0.98 and 0.68, respectively.  In the case of CAPM, it’s not always easy to calculate the market return and beta for an investor.

In the final analysis

The cost of equity measures how much returns a company has to produce to keep its shareholders invested in the company and raise additional capital whenever necessary to keep operations flowing.

The cost of equity is a great measure for an investor to understand whether to invest in a company or not. But instead of looking at just this, if they look at WACC (Weighted Average Cost of Capital), that would give them a holistic picture as the cost of debtCost Of DebtCost of debt is the expected rate of return for the debt holder and is usually calculated as the effective interest rate applicable to a firms liability. It is an integral part of the discounted valuation analysis which calculates the present value of a firm by discounting future cash flows by the expected rate of return to its equity and debt holders.read more also affects the dividend payment for shareholders.

Cost of Equity CAPM Video

  • Alpha FormulaAlpha FormulaThe term alpha refers to an index that is used in a variety of financial models, including the capital asset pricing model, to determine the maximum possible return from a low-risk investment. Alpha of portfolio = Actual rate of return of portfolio – Risk-free rate of return – β * (Market return – Risk-free rate of return)read moreCalculation of Cost of Capital FormulaFormula for Cost of EquityFormula For Cost Of EquityCost 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