How to calculate cost of equity
The cost of equity is a crucial metric for any company, as it represents the return required by shareholders to maintain their investment in the business. It is an essential input in capital budgeting decisions, and calculating it accurately can help guide a company’s growth and expansion strategy. In this article, we will explore different methods for calculating the cost of equity and discuss their respective benefits and drawbacks.
1. Dividend Growth Model (also known as Gordon Growth Model)
One popular method to calculate the cost of equity is the Dividend Growth Model. This approach focuses on dividend payments to shareholders and assumes that dividends will grow at a constant rate indefinitely.
Cost of Equity = (Dividends per Share / Current Market Price) + Dividend Growth Rate
To calculate the cost of equity using this model, simply divide the company’s expected dividends per share for the next year by its current market price per share, and add the expected dividend growth rate.
– Easy to understand and apply
– Good for companies with consistent dividend policies
– Not suitable for companies that do not pay dividends
– Assumes constant dividend growth rate which may not always be accurate
2. Capital Asset Pricing Model (CAPM)
The Capital Asset Pricing Model (CAPM) is another widely used approach for calculating cost of equity. This model establishes a relationship between a company’s systematic risk (measured by beta) and its expected return on equity.
Cost of Equity = Risk-free Rate + Beta * (Market Return – Risk-free Rate)
In the CAPM formula:
– Risk-free Rate: Represents the return on a risk-free security such as government bonds
– Beta: Measures how sensitive a stock’s returns are relative to the overall market
– Market Return: The expected return on the entire stock market
– Considers risk, making it more suitable for volatile stocks
– Widely accepted and used in the financial industry
– Assumes linear relationship between risk and return, which may not always hold true
– Estimating market return and risk-free rate can be challenging
3. Bond Yield Plus Risk Premium (BYPRP)
The Bond Yield Plus Risk Premium approach calculates the cost of equity by adding a risk premium to the company’s bond yield. This method is based on the premise that the shareholders require a return above the company’s debt cost to compensate for the additional risk.
Cost of Equity = Company’s Bond Yield + Risk Premium
To apply this method, determine the yield on the company’s long-term bonds and add an appropriate risk premium.
– Considers both debt and equity financing costs
– Useful for companies with significant debt
– Requires knowledge of bond yield and risk premium values, which may be difficult to estimate
There is no one-size-fits-all solution when it comes to calculating a company’s cost of equity, as each method has its own set of assumptions and limitations. Choosing the most appropriate approach will depend on factors such as dividend payments, stock volatility, and access to financial data. By understanding how each model works and its underlying principles, analysts can make informed decisions about which method best suits their needs in calculating cost of equity for a specific company.