Definition: The cost of equity is the return that investors expect from a security as reimbursement for the risk they undertake by investing in the particular security. In other words, it’s the amount of return that investors require before they start looking for better investments that will pay more.
What Does Cost of Equity Mean?
What is the definition of cost of equity? Typically, to calculate the cost of equity we use the capital asset pricing model (CAPM), which portrays how the market mechanisms determine the value of a security. Investors agree to buy a security, only if they expect a return that reimburses them for the risk they have undertaken to reap a negative return. If the risk is lower with another company, they will choose to invest elsewhere.
To calculate the equity cost, Rs, using the CAPM formula: Rs = rf + b x (rm – rf).
The CAPM calculation can be cross-checked with the dividend discount model (DCF). In this case, we need to know:
- D1 = the annualized dividend in year 1
- P = the stock price
- g = the dividend growth rate
Thus, the cost of equity formula using the DCF model is calculates like this: Rs = (D1 / P) + g.
Let’s look at an example.
Anne works as an investment analyst at JPMorgan Chase. She wants to calculate the CoE of a security using CAPM. Anne knows that the risk-free rate is 4%, the projected market return is 10.6%, and the security beta is 1.35.
Using CAPM, Anna finds that the CoE of the security is:
Rs = rf + b x (rm – rf) = 4% + [1.35 x (10.6% – 4%)] = 0.04 + [1.35 x 0.066) = 0.04 + 0.0891 = 0.1291 = 12.9%
Then, Anne wants to compare the CAPM findings with the DCF model. She knows that the current stock price is $50, the projected dividend is $3.30, and the dividend growth is 4.8%. Using DCF, Anne finds that the CoE of the security is:
Rs = (D1 / P) + g = $3.30 / $50 + 4.8% = 0.066 + 0.048 = 0.1144 = 11.4%
Note: The DCF model does not apply to securities that do not pay dividends.
Define Cost of Equity: Cost of equity is the return that companies can expect to pay their shareholders to maintain current investors and encourage new investors in the future.