Cost of equity refers to a shareholder's required rate of return on an equity investment. It is the rate of return that could have been earned by putting the same money into a different investment with equal risk. How It Works/Example:
The cost of equity is the rate of return required to persuade an investor to make a given equity investment.
In general, there are two ways to determine cost of equity.
First is the dividend growth model:
Cost of Equity = (Next Year's Annual Dividend / Current Stock Price) + Dividend Growth Rate
Second is the Capital Asset Pricing Model (CAPM):
ra = rf + Ba (rm-rf)
rf = the rate of return on risk-free securities (typically Treasuries) Ba = the beta of the investment in question
rm = the market's overall expected rate of return
Let's assume the following for Company XYZ:
Next year's dividend: $1
Current stock price: $10
Dividend growth rate: 3%
Using the dividend growth model, we can calculate that Company XYZ's cost of capital is ($1 / $10 ) + 3% = 13%
Using CAPM, we can calculate that Company XYZ's cost of capital is 3% + 1.0*(12% - 3%) = 12% Why It Matters:
Cost of equity is a key component of stock valuation. Because an investor expects his or her equity investment to grow by at least the cost of equity, cost of equity can be used as the discount rate used to calculate an equity investment's fair value.
Both cost of equity calculation methods have advantages and disadvantages.
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