Cost of equity calculator is a tool that calculates the cost of equity - the rate of return a company theoretically pays to its equity investors to compensate them for the risk they undertake by investing their capital into the company. If you are looking to learn how to calculate the cost of equity, do not hesitate to read the next section to find more details about the cost of equity formulas.
Cost of Equity - what is it?
Cost of Equity informs us about the return shareholders request for investing in a given company. It is what the market requires for possessing shares, and handling with the risk connected with that - so we can say that it is compensation.
The cost of equity also lets us evaluate the attractiveness of an investment and how risky it is. The relation it simple: the higher the risk, the higher the cost, and once the risk decreases, the cost of equity also becomes lower.
Companies obtain capital mainly from two different sources - loans and equity investors. The equity investors seek a return on their investment, by way of the appreciation of their investment or the dividend. From the company's perspective, it is the cost that they should cover to get more cash.
Cost from loans is the cost of the company's debt. Cost of equity is a little more challenging to calculate, but you will learn more in the how to calculate the cost of equity section below. Once the company is using both sources, the best way to calculate its cost would be to use the WACC calculator.
How to calculate the cost of equity
There are two different approaches to calculating the cost of equity; they depend on the company's dividend policy - whether the company is sharing the return with shareholders or not.
Once the company is paying dividends, the calculations become as simple as using the dividend capitalization model. If the company is not paying dividends, the cost of equity should be calculated based on the CAPM - Capital Asset Pricing Model.
- The cost of equity formula, based on the CAPM model, requires:
- Risk-free rate of return - return from investments which is considered as free of risk;
- Market rate of return - an average return from a stock market investment; and
- Beta coefficient - a measurement of how a company's shares respond to changes at the market; it shows how much volatile the stock is.
- The cost of equity, based on the dividend capitalization model, requires:
- Dividend per share (DPS) - the amount of dividend per one share that will be paid next year;
- Current market value (CMV) - the present value on the stock exchange; and
- Growth rate of dividend (GRD) - the change in % value between the current and past dividend.
Cost of Equity formula
As mentioned in the previous section, there are two ways to calculate the cost of equity. The first one is based on the CAPM model, and the second - the dividend capitalization model. The second one is simpler, but keep in mind that it may be used only when the company is paying dividends!
The cost of equity formula based on CAPM model:
Cost of Equity = Risk-Free Rate of Return + Beta * (Market Rate of Return - Risk-Free Rate of Return)
The formula based on the dividend capitalization model (abbreviations explained in previous section):
Cost of Equity = (DPS / CMV) + GRD
Let's go through an example of a dividend capitalization model calculation. Imagine a company has a current market value of $70. The company announced that their dividend this year will be $2 per share, and this value will grow by 3% each year. Cost of equity for this company is calculated as follows:
Cost of Equity = (DPS / CMV) + GRD = ($2 / $70) + 3% = 5.857%
We may understand this value as a company's cost. To obtain additional an $100 in cash from investors right now, they would have to theoretically pay them $105.86 in the future.