Cost of Equity

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.

It is one of the most significant attributes that you need to look at before you think of 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?

Cost of Equity

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Source: Cost of Equity (wallstreetmojo.com)

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 investor requires from the stock before looking into other viable opportunities.

Most Important – Download Cost of Equity (Ke) Template

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

If we can go back and look at the concept of “opportunity cost,” we will understand it better. Suppose you have the US $1000 to invest! So you look for many opportunities. And you choose the one which, according to you, would yield more returns. Now, 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 their effort to increase the required rate of return (hint – pay the dividendDividendDividend is that portion of profit which is distributed to the shareholders of the company as the reward for their investment in the company and its distribution amount is decided by the board of the company and thereafter approved by the shareholders of the company.read more and put effort so that the share price appreciates).

Let’s take an example to understand this.

Let’s say Mr. A wants to invest in Company B., But as Mr. A is a relatively new investor, he wants a low-risk stock, which 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 for him would 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 over and over again. 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 Model

Mr. C wants to invest into Berry Juice Private Limited. Currently, Berry Juice Private Limited has decided to pay the US $2 per share as a dividend. The current market value of the stock is the 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 Ratio) * Return on Equity

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

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 Equity

Return on Equity = Net Income / Total Equity

In the example section, we will 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.

Cost of Equity CAPM

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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)

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 section.
  • Ke = 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. It is the rate which 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 is the Ke of a company! 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 StatementStatement of Cash flow is a statement in financial accounting which reports the details about the cash generated and the cash outflow of the company during a particular accounting period under consideration from the different activities i.e., operating activities, investing activities and financing activities.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 analysis.

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 of the models and would try to understand how things work.

Example # 1

In US $Company A
Dividends Per Share12
Market Price of Share100
Growth in the next year5%

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

In US $Company A
Dividends Per Share (A)12
Market Price of Share (B)100
Growth in the next year (C)5%
Ke[(A/B)+C]17%

So, Ke of Company A is 17%.

Example # 2

MNP Company has the following information –

DetailsCompany MNP
Risk-Free Rate 8%
Market Rate of Return12%
Beta Coefficient1.5 

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)

DetailsCompany MNP
Risk-Free Rate (A)8%
Market Rate of Return (B)12%
[B – A] (C)4%
Beta Coefficient (D)1.5
Ke [A+D*C]14%

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 closing price of the stock every day for a particular period, also the closing level of the market benchmark (usually S&P 500) for the 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

Most Important – Download Cost of Equity (Ke) Template

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

#1 – RISK-FREE RATE

Here, I have considered a 10 year Treasury Rate as the Risk-free rate. Please note that 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.

Risk Free Rate

source – bankrate.com

EQUITY RISK PREMIUM (RM – RF)

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%.

Equity Risk Premium - US

source – stern.nyu.edu

BETA

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

We note that the Beta of Starbucks is at 0.794x

Starbucks Beta

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 that is unique to each of the companies. Beta gives us a numerical measure of how volatile the stock is as compared to the stock market. The higher the volatility, the Risky is the stock.

Please note –

  1. Risk-Free Rates and Market Premium is the same across sectors.
  2. 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 is the same for all the companies. It is the beta that changes.

S. NoNameMarket Cap ($ million)Risk-Free RateBeta (5Y)Market PremiumKe (R(f) + Market Premium x Beta)
1National Grid  47,5752.42%0.42265.69%4.8%
2Dominion Resources    46,8562.42%0.25515.69%3.9%
3Exelon  33,2832.42%0.27225.69%4.0%
4Sempra Energy    26,6262.42%0.475.69%5.1%
5Public Service Enterprise    22,4262.42%0.33425.69%4.3%
6FirstEnergy   13,3532.42%0.1485.69%3.3%
7Entergy  13,2392.42%0.42245.69%4.8%
8Huaneng Power   10,5792.42%0.5475.69%5.5%
9Brookfield Infrastructure     9,6062.42%1.04575.69%8.4%
10AES    7,7652.42%1.15065.69%9.0%

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%.
  • This is because most companies have a beta of less than 1.0. This implies that these stocks are not very sensitive to the movement of the stock markets.
  • Outliers here are Brookfield Infrastructure and AES that 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.

S. NoNameMarket Cap ($ million)Risk-Free RateBeta (5Y)Market PremiumKe (R(f) + Market Premium x Beta)
1ArcelorMittal 28,4002.42%2.38385.69%16.0%
2POSCO  21,8802.42%1.01085.69%8.2%
3Nucor  20,5392.42%1.44785.69%10.7%
4Tenaris20,1812.42%0.90675.69%7.6%
5Steel Dynamics  9,1652.42%1.35325.69%10.1%
6Gerdau  7,4452.42%2.25745.69%15.3%
7United States Steel 7,1692.42%2.75755.69%18.1%
8Reliance Steel & Aluminum  6,3682.42%1.31585.69%9.9%
9Companhia Siderurgica   5,5512.42%2.14835.69%14.6%
10Ternium  4,6512.42%1.12165.69%8.8%

source:ycharts

  • On average, we note that the Ke for the steel sector is high. Most companies have Ke in excess of 10%.
  • This 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 the 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.

S. NoNameMarket Cap ($ million)Risk-Free RateBeta (5Y)Market PremiumKe (R(f) + Market Premium x Beta)
1McDonald’s  104,8062.42%0.69425.69%6.4%
2Yum Brands  34,6062.42%0.75955.69%6.7%
3Chipotle Mexican Grill    12,4402.42%0.59125.69%5.8%
4Darden Restaurants  9,5232.42%0.28235.69%4.0%
5Domino’s Pizza   9,1052.42%0.65125.69%6.1%
6Aramark  8,8602.42%0.47735.69%5.1%
7Panera Bread    5,3882.42%0.31225.69%4.2%
8Dunkin Brands Group 5,0392.42%0.1965.69%3.5%
9Cracker Barrel Old  3,8542.42%0.39455.69%4.7%
10Jack In The Box  3,4722.42%0.5485.69%5.5%

source:ycharts

  • 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.

S. NoNameMarket Cap ($ million)Risk-Free RateBeta (5Y)Market PremiumKe (R(f) + Market Premium x Beta)
1Alphabet587,2032.42%0.98425.69%8.0%
2Facebook  386,4482.42%0.68025.69%6.3%
3Baidu 64,3942.42%1.90075.69%13.2%
4Yahoo! 43,4132.42%1.60255.69%11.5%
5NetEase 38,5812.42%0.71635.69%6.5%
6Twitter 11,7392.42%1.16955.69%9.1%
7VeriSign 8,5542.42%1.19965.69%9.2%
8Yandex  7,8332.42%2.85975.69%18.7%
9IAC/InterActive  5,9292.42%1.12215.69%8.8%
10SINA  5,5992.42%1.16655.69%9.1%

source:ycharts

  • Internet and Content companies have a varied Cost of Equity. This 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.

S. NoNameMarket Cap ($ million)Risk-Free RateBeta (5Y)Market PremiumKe (R(f) + Market Premium x Beta)
1Coca-Cola   178,8152.42%0.69095.69%6.4%
2PepsiCo  156,0802.42%0.53375.69%5.5%
3Monster Beverage   25,1172.42%0.76865.69%6.8%
4Dr. Pepper Snapple Group  17,3152.42%0.55365.69%5.6%
5Embotelladora Andina 3,6582.42%0.20065.69%3.6%
6National Beverage 2,7392.42%0.57815.69%5.7%
7Cott1,5662.42%0.52365.69%5.4%

source:ycharts

Limitations

There are a couple of limitations we need to consider –

  • First, the growth rate can always be estimated by the investor. The investor only can estimate what the dividend appreciation was in the previous year (if any) and then can assume that the growth would be similar in the next year.
  • In the case of CAPM, for an investor, it’s not always easy to calculate the market return and beta.

In the final analysis

The cost of equity is a measure of 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 debt also affects the dividend payment for shareholders.

Cost of Equity CAPM Video

 

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  1. Anand jha says

    Nice and knowledgeable blog

  2. Anand jha says

    Nice & knowledgeable blog