Cost of Equity Formula

Formula of Cost of Equity (Table of Contents)

• What is Cost of Equity Formula?
  • Method 1 – Cost of Equity Formula for Dividend Companies
  • Method 2 – Cost of Equity using CAPM
• Cost of Equity Formula Calculator

What is Cost of Equity Formula?

Cost of equity (Ke) is what shareholders expect for investing 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 Model

We will discuss each of the methods in detail.

Method #1 – Cost of Equity Formula for Dividend Companies

Where,

• DPS = Dividend Per Share
• 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.

Cost of Equity Formula

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

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 trading currently 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.

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 of 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 dividend for time being.

The Share price of Infosys is 678.95 (BSE) and its average dividend growth 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 Cost of Equity using Capital Asset Pricing Model.

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 premium which is nothing but a differential of Market Return and Risk-Free Rate.

In the CAPM equation, the risk-free rate (Rf) 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.

Solution:

First, we will calculate the equity risk premium 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 CAPM Model

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

For 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 Formula Calculator

You can use the following Cost of Equity Formula Calculator.

 

Relevance and Use of Cost of Equity formula

• A firm uses a cost of equity (Ke) to assess the relative attractiveness of its opportunities in 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 Analyst, Buy or sell side Analyst, etc. who are majorly involve in financing modelling and issue research reports uses the cost of equity to arrive at 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 a cost of equity which are running a regression analysis, multi-factor model, survey method etc.

Cost of Equity Formula in Excel (with excel template)

Now let us take the case mentioned in the above Cost of Equity Formula Example #1 to illustrate the same in excel template below.

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

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

In the below given excel template, we have used the calculation of Cost of Equity Equation to find the Cost of Equity.

So the calculation of the Cost of equity will be-

Recommended Articles:

This has been a guide to Cost of Equity Formula. Here we learn the two methods to calculate the cost of equity 1) for dividend-paying companies 2) using CAPM Model along with practical examples and concepts. You may learn more about valuations from the following articles –

• Examples of Market Risk Premium Formula
• Explanation of the Total Equity Formula
• What is Dividend Growth Rate?
• Explanation of the Volatility Formula
• What is Equity Financing?
• Gordon Growth Model Formula
• Security Market Line Interpretation
• Top 5 Equity Valuation Models
• Calculate Beta Coefficient in Excel