Cost of Equity Formula

What is 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. Cost of Equity formula can be calculated through below two methods:

Method 1 – Cost of Equity Formula for Dividend Companies
Method 2 – Cost of Equity Formula using CAPM ModelCAPM Model The 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

Cost of Equity (K_e) = DPS/MPS + r

Where,

DPS = Dividend Per ShareDividend Per Share Dividends 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 more
MPS = Market Price per Share
r = Growth rate of Dividends

The dividend growth model requires that a company pays dividends, and it is based on upcoming dividends. The logic behind the equation is that the company’s obligation to pay dividends is the cost of paying its shareholders and, therefore, the Ke, i.e., cost of equity. This is a limited model in its interpretation of costs.

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For eg:
Source: Cost of Equity Formula (wallstreetmojo.com)

Cost of Equity Calculations

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

You can download this Cost of Equity Formula Excel Template here – Cost of Equity Formula Excel Template

Example #1

Let’s try the calculation for Cost of Equity formula with a 1^st formula where we assume a company is paying regular dividends.

Suppose a company named XYZ is a regularly paying dividend company, and its stock price is currently trading at 20 and expects to pay a dividend of 3.20 next year has following dividend payment history. Calculate the cost of equity of the company.

Year	Dividend Per Share
1	3.00
2	3.02
3	3.05
4	3.11
5	3.16

Solution:

Let’s first calculate the average growth rate of dividends. Continuing the same formula as per below will yield yearly growth rates.

So the growth rate for all the years will be-

Now 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 the XYZ company will be 17.31%.

Example #2 – Infosys

Below is the dividend history of the company, ignoring interim and any special dividendSpecial Dividend The 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.

Announcement Date	Effective Date	Dividend Type	Dividend (%)	Remarks	Dividend Per Share
12/04/2018	14/06/2018	Final	410	Rs. 20.5000 per share (410%) Final Dividend	20.50
13/04/2017	01/06/2017	Final	295	Rs. 14.7500 per share (295%) Final Dividend	14.75
15/04/2016	09/06/2016	Final	285	Rs. 14.2500 per share (285%) Final Dividend	14.25
24/04/2015	15/06/2015	Final	590	Rs. 29.5000 per share (590%) Final Dividend (equivalent to Rs 14.75/- per share after 1.1 bonus issue)	29.50
15/04/2014	29/05/2014	Final	860	Rs. 43.0000 per share (860%) Final Dividend	43.00
12/04/2013	30/05/2013	Final	540	Rs. 27.0000 per share (540%) Final Dividend	27.00
13/04/2012	24/05/2012	Final	640	Rs. 22.00 per share (440%) Final Dividend & Rs.10.00 per share (200%) Special Dividend	22.00

The Share price of Infosys is 678.95 (BSE), and its average dividend growthDividend Growth Dividend 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, and it paid last dividend 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 formula of the Cost of Equity using the Capital Asset Pricing ModelCapital Asset Pricing Model The 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.

Where,

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

The capital asset pricing model (CAPM), however, can be used on n number of stock, 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 Premium The 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 goes, 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 eleven to twelve % over the past eighty years. In general, a company with a high beta will have a high degree of risk and will pay more for equity.

Example #1

Below, inputs have been arrived for the three companies, calculate its cost of equity.

Particulars	X	Y	Z
Risk Free Beta	3.00%	3.40%	4.00%
Beta	1.11	0.98	1.4
Market Return	7.00%	7.00%	7.00%

Solution:

First, we will calculate the equity risk premiumThe Equity Risk Premium Equity 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. [E(m) – R(f)]

Then we will calculate 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 as per above for all the company, we will get the cost of equity.

So, the cost of equity for 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’s try the calculation of the cost of equity for TCS through CAPM Model.

For the time being, we will take 10-year Govt Bond yield as Risk-Free Rate as 7.46%

Source: https://countryeconomy.com

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

Source: http://pages.stern.nyu.edu/

For India, Equity Risk Premium is 7.27%.

Now we need 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%

Cost of Equity Calculations

You can use the following Cost of Equity Formula Calculator.

Dividend per Share
Market price per Share
Growth Rate of Dividends
Cost of Equity Formula =

Cost of Equity Formula = =

Dividend per Share
	+ Growth Rate of Dividends	=
Market price per Share

0
	+0	=	0
0

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 both external projects and internal acquisition. Companies will typically use a combination of debt and equity financing, with equity capital is 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 AnalystResearch Analyst Research 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 involve in financing modeling and issue research reports uses the cost of equity to arrive at the valuation of the companies they follow and then accordingly advise whether the stock is over or under value and then take an investment decision based on that.
There are many other methods also used to compute the cost of equity, which are running a regression analysis, multi-factor modelMulti-factor Model Factor 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.