# Cost of Equity | Formula | CAPM & Dividend Growth Model

Cost of Equity – The Cost of Equity is one of the most significant attributes that you need to look at before you think of investing in the company’s shares. Let us look at the graph above. The Cost of Equity for Yandex is 18.70%, while that of Facebook is 6.30%. What does this mean? How would you calculate it? What metrics do you need to be aware of while looking at Cost of Equity?

We will look at all of it in this article.

• What is Cost of Equity?
• Cost of Equity Formula – CAPM & Dividend Discount Model
• #1 – Cost of Equity – Dividend Discount Model
• #2- Cost of Equity – Capital Asset Pricing Model (CAPM)
• Interpretation of Cost of Equity
• Cost of Equity Example
• Example # 1 Cost of Equity – Dividend Discount Model
• Example # 2 Cost of Equity – CAPM
• Cost of Equity CAPM Example – Starbucks
• Industry Cost of Equity
• #1 – Utilities Companies Cost of Equity
• #2 – Steel Sector Cost of Equity
• #3 – Cost of Equity – Restaurant Sector
• #4 – Cost of Equity – Internet & Content
• #5 – Cost of Equity – Beverages
• Limitations of Cost of Equity
• In the final analysis

## What is Cost of Equity?

Cost of Equity is an important measure for investors who want to invest into a company. The cost of equity is the Rate of return investor requires from a stock before looking into other viable opportunities.

If we can go back and look at the concept of “opportunity cost”, we will understand it better. Suppose, you have US \$1000 to invest! So you look for many opportunities. And you choose the one which according to you would yield more returns. Now as you decided to invest into one particular opportunity, you would let go of others, maybe more profitable opportunities. That loss of other alternatives is called “opportunity cost”.

Let’s come back to the cost of equity. If you, as an investor, don’t get better returns from company A; you will go ahead and invest in other companies. And company A has to bear the opportunity cost if they don’t put their effort to increase the required rate of return (hint – pay the dividend and put effort so that the share price appreciates).

Let’s take an example to understand this.

Let’s say Mr A wants to invest into Company B. But as Mr A is a relatively new investor, he wants a low risk stock which can yield him good return. Company B’s current stock price is US \$8 per share and Mr A expects that the required rate of return for him would be more than 15%. And through the calculation of cost of equity, he will understand what he will get as a required rate of return. If he gets 15% or more, he will invest into the company; and if not, he will look for other opportunities.

## Cost of Equity Formula – CAPM & Dividend Discount Model

Cost of Equity can be computed two ways. First, we will use the usual model which has been used by the investors over and over again. And then we would look at the other one.

#### #1 – Cost of Equity – Dividend Discount Model

So we need to compute cost of equity in the following manner –

Cost of Equity = (Dividends per share for next year / Current Market Value of Stock) + Growth rate of dividends

Here, it is computed by taking dividends per share into account. So here’s an example to understand it better.

Learn more about Dividend Discount Model

Mr C wants to invest into Berry Juice Private Limited. Currently, Berry Juice Private Limited has decided to pay US \$2 per share as dividend. The current Market value of the stock is the US \$20. And Mr C expects that the appreciation in the dividend would be around 4% (a guess based on the previous year’s data). So, the cost of equity would be 14%.

How would you calculate the growth rate? We need to remember that growth rate is the estimated one and we need to compute it in the following manner –

Growth Rate = (1 – Payout Ratio) * Return on Equity

If we are not being provided with the Payout Ratio and Return on Equity Ratio, we need to calculate it.

Here’s how to calculate them –

Dividend Payout Ratio = Dividends / Net Income

We can use another ratio to find out dividend pay-out. Here it is –

Alternative Dividend Payout Ratio = 1 – (Retained Earnings / Net Income)

And also the Return on Equity –

Return on Equity = Net Income / Total Equity

In the example section, we will the practical application of all of these.

#### #2- Cost of Equity – Capital Asset Pricing Model (CAPM)

CAPM quantifies the relationship between risk and required return in a well-functioning market.

Here’s the Cost of Equity CAPM formula for your reference.

Cost of Equity = Risk-Free Rate of Return + Beta * (Market Rate of Return – Risk-free Rate of Return)

• Risk-free Rate of Return – This is the return of a security that has no default risk, no volatility, and beta of zero. Ten-year government bond is typically taken as risk-free rate
• Beta is a statistical measure percentage of the variability of a company’s stock price in relation to the stock market overall. So if the company has high beta, that means the company has more risk and thus, the company needs to pay more to attract investors. Simply put, that means more cost of equity.
• Risk Premium (Market Rate of Return – Risk-Free Rate) – It measure of the return that equity investors demand over a risk-free rate in order to compensate them for the volatility/risk of an investment which matches the volatility of the entire market. Risk premium estimates vary from 4.0% to 7.0%

Let’s take an example to understand this. Let’s say the beta of Company M is 1 and risk-free return is 4%. The market rate of return is 6%. We need to compute the cost of equity using CAPM model.

• Company M has a beta of 1 that means the stock of Company M will increase or decrease as per the tandem of the market. We will understand more of this in the later section.
• Cost of Equity = Risk-Free Rate of Return + Beta * (Market Rate of Return – Risk-free Rate of Return)
• Cost of Equity = 0.04 + 1 * (0.06 – 0.04) = 0.06 = 6%.

## Interpretation of Cost of Equity

The Cost of Equity is not exactly what we refer to. It’s a responsibility of the company. It is the rate which the company needs to generate to allure the investors to invest in their stock at the market price.

That’s why the cost of equity is also referred to as “required rate of return”.

So let’s say as an investor you don’t have any idea what is the cost of equity of a company! What would you do?

First, you need to find out the total equity of the company. If you look at the balance sheet of the company, you would find it easily. Then you need to see whether the company has paid any dividends or not. You can check their cash flow statement to be ensured. If they pay a dividend, you need to use the dividend discount model (mentioned above) and if not, you need to go ahead and find out the risk-free rate and compute the cost of equity under capital asset pricing model (CAPM). Computing it under CAPM is a tougher job as you need to find out the beta by doing regression analysis.

Let’s have a look at the examples about how to compute the cost of equity of a company under both of these models.

## Cost of Equity Example

We will take examples from each of the models and would try to understand how things work.

#### Example # 1 Cost of Equity – Dividend Discount Model

 In US \$ Company A Dividends Per Share 12 Market Price of Share 100 Growth in the next year 5%

Now, this is the simplest example of dividend discount model. We know that dividend per share is US \$30 and market price per share is US \$100. We also know the growth percentage.

Let’s compute the cost of equity.

Cost of Equity = (Dividends per share for next year / Current Market Value of Stock) + Growth rate of dividends

 In US \$ Company A Dividends Per Share (A) 12 Market Price of Share (B) 100 Growth in the next year (C) 5% Cost of Equity [(A/B)+C] 17%

So, cost of equity of Company A is 17%.

#### Example # 2 Cost of Equity – CAPM

MNP Company has the following information –

 Details Company MNP Risk Free Rate 8% Market Rate of Return 12% Beta Coefficient 1.5

We need to compute Cost of Equity of MNP Company.

Let’s look at the formula first and then we will ascertain the cost of equity using capital asset pricing model.

Cost of Equity = Risk-Free Rate of Return + Beta * (Market Rate of Return – Risk-free Rate of Return)

 Details Company MNP Risk-Free Rate (A) 8% Market Rate of Return (B) 12% [B – A] (C) 4% Beta Coefficient (D) 1.5 Cost of Equity [A+D*C] 14%

Note: To calculate the beta coefficient for a single stock, you need to look at the closing price of the stock every day for a particular period, also the closing level of the market benchmark (usually S&P 500) for the similar period and then use excel in running the regression analysis.

## Cost of Equity CAPM Example – Starbucks

Let us take an example of Starbucks and calculate Cost of Equity using CAPM model.

Cost of Equity CAPM Ke = Rf + (Rm – Rf) x Beta

##### #1 – RISK-FREE RATE

Here, I have considered 10 year Treasury Rate as the Risk-free rate. Please note that some analyst also take a 5 year treasury rate as the risk-free rate. Please check with your research analyst before taking a call on this.

source – bankrate.com

##### EQUITY RISK PREMIUM (RM – RF)

Each country has a different Equity Risk Premium. Equity Risk Premium primarily denotes the premium expected by the Equity Investor.

For the United States, Equity Risk Premium is 6.25%.

source – stern.nyu.edu

##### BETA

Let us now look at Starbucks Beta Trends over the past few years. Beta of Starbucks has decreased over the past five years. This means that Starbucks stocks are less volatile as compared to the stock market.

We note that Beta of Starbucks is at 0.794x

source: ycharts

With this, we have all the necessary information to calculate the cost of equity.

Cost of Equity = Ke = Rf + (Rm – Rf) x Beta

Ke = 2.42% + 5.69% x 0.794

Cost of Equity  =6.93%

## Industry Cost of Equity

Cost of equity can differ across industries. As we saw from the CAPM formula above, Beta is the only variable that is unique to each of the companies. Beta gives us a numerical measure of how volatile the stock is as compared to the stock market. Higher the volatility, Risky is the stock.

Please note –

1. Risk-Free Rates and Market Premium is same across sectors.
2. However, Market premium differs with each country.

## #1 – Utilities Companies Cost of Equity

Let us look at the Cost of Equity of Top Utilities Companies. Below table provides us with the Market Cap, Risk-Free Rate, Beta, Market Premium and cost of equity data.

Please note that Risk-Free Rate and Market Premium is same for all the companies. It is the beta that changes.

 S. No Name Market Cap (\$ million) Risk Free Rate Beta (5Y) Market Premium Cost of Equity (R(f) + Market Premium x Beta) 1 National Grid 47,575 2.42% 0.4226 5.69% 4.8% 2 Dominion Resources 46,856 2.42% 0.2551 5.69% 3.9% 3 Exelon 33,283 2.42% 0.2722 5.69% 4.0% 4 Sempra Energy 26,626 2.42% 0.47 5.69% 5.1% 5 Public Service Enterprise 22,426 2.42% 0.3342 5.69% 4.3% 6 FirstEnergy 13,353 2.42% 0.148 5.69% 3.3% 7 Entergy 13,239 2.42% 0.4224 5.69% 4.8% 8 Huaneng Power 10,579 2.42% 0.547 5.69% 5.5% 9 Brookfield Infrastructure 9,606 2.42% 1.0457 5.69% 8.4% 10 AES 7,765 2.42% 1.1506 5.69% 9.0%

source:ycharts

• We note that Cost of Equity for Utilities companies is pretty low. Most of the stocks in this sector have cost of equity between 3%-5%.
• This is because most companies have a beta of less than 1.0. This implies that these stocks are not very sensitive to the movement of the stock markets.
• Outliers here are Brookfield Infrastructure and AES that have the cost of equity of 8.4% and 9.4%, respectively.

## #2 – Steel Sector Cost of Equity

Let’s now take the example of Stell Sector’s cost of equity.

 S. No Name Market Cap (\$ million) Risk Free Rate Beta (5Y) Market Premium Cost of Equity (R(f) + Market Premium x Beta) 1 ArcelorMittal 28,400 2.42% 2.3838 5.69% 16.0% 2 POSCO 21,880 2.42% 1.0108 5.69% 8.2% 3 Nucor 20,539 2.42% 1.4478 5.69% 10.7% 4 Tenaris 20,181 2.42% 0.9067 5.69% 7.6% 5 Steel Dynamics 9,165 2.42% 1.3532 5.69% 10.1% 6 Gerdau 7,445 2.42% 2.2574 5.69% 15.3% 7 United States Steel 7,169 2.42% 2.7575 5.69% 18.1% 8 Reliance Steel & Aluminum 6,368 2.42% 1.3158 5.69% 9.9% 9 Companhia Siderurgica 5,551 2.42% 2.1483 5.69% 14.6% 10 Ternium 4,651 2.42% 1.1216 5.69% 8.8%

source:ycharts

• On an average, we note that the cost of equity for steel sector is high. Most companies have cost of equity in excess of 10%.
• This is because of higher betas of steel companies. Higher beta implies that steel companies are sensitive to the stock market movements and can be a risky investment. United States Steel has a beta of 2.75 with cost of Equity of 18.1%
• Posco has the lowest cost of equity among these companies at 8.2% and a beta of 1.01.

## #3 – Cost of Equity – Restaurant Sector

Let us now take Cost of Equity Example from Restaurant Sector.

 S. No Name Market Cap (\$ million) Risk Free Rate Beta (5Y) Market Premium Cost of Equity (R(f) + Market Premium x Beta) 1 McDonald’s 104,806 2.42% 0.6942 5.69% 6.4% 2 Yum Brands 34,606 2.42% 0.7595 5.69% 6.7% 3 Chipotle Mexican Grill 12,440 2.42% 0.5912 5.69% 5.8% 4 Darden Restaurants 9,523 2.42% 0.2823 5.69% 4.0% 5 Domino’s Pizza 9,105 2.42% 0.6512 5.69% 6.1% 6 Aramark 8,860 2.42% 0.4773 5.69% 5.1% 7 Panera Bread 5,388 2.42% 0.3122 5.69% 4.2% 8 Dunkin Brands Group 5,039 2.42% 0.196 5.69% 3.5% 9 Cracker Barrel Old 3,854 2.42% 0.3945 5.69% 4.7% 10 Jack In The Box 3,472 2.42% 0.548 5.69% 5.5%

source:ycharts

• Restaurant companies have low cost of equity. This is because their beta is less than 1.
• Restaurant Companies seems to be a cohesive group with cost of equity ranging between 3.5% and 6.7%.

## #4 – Cost of Equity – Internet & Content

Examples of Internet and Content Companies include Alphabet, Facebook, Yahoo etc.

 S. No Name Market Cap (\$ million) Risk Free Rate Beta (5Y) Market Premium Cost of Equity (R(f) + Market Premium x Beta) 1 Alphabet 587,203 2.42% 0.9842 5.69% 8.0% 2 Facebook 386,448 2.42% 0.6802 5.69% 6.3% 3 Baidu 64,394 2.42% 1.9007 5.69% 13.2% 4 Yahoo! 43,413 2.42% 1.6025 5.69% 11.5% 5 NetEase 38,581 2.42% 0.7163 5.69% 6.5% 6 Twitter 11,739 2.42% 1.1695 5.69% 9.1% 7 VeriSign 8,554 2.42% 1.1996 5.69% 9.2% 8 Yandex 7,833 2.42% 2.8597 5.69% 18.7% 9 IAC/InterActive 5,929 2.42% 1.1221 5.69% 8.8% 10 SINA 5,599 2.42% 1.1665 5.69% 9.1%

source:ycharts

• Internet and Content companies have a varied Cost of Equity. This is because of the diversity in the Beta of the companies.
• Yandex and Baidu have a very high beta of 2.85 and 1.90, respectively. On the other hand, Companies like Alphabet and Facebook are fairly stable with Beta of 0.98 and 0.68, respectively.

## #5 – Cost of Equity – Beverages

Now let us look at Cost of Equity examples from Beverage Sector.

 S. No Name Market Cap (\$ million) Risk Free Rate Beta (5Y) Market Premium Cost of Equity (R(f) + Market Premium x Beta) 1 Coca-Cola 178,815 2.42% 0.6909 5.69% 6.4% 2 PepsiCo 156,080 2.42% 0.5337 5.69% 5.5% 3 Monster Beverage 25,117 2.42% 0.7686 5.69% 6.8% 4 Dr Pepper Snapple Group 17,315 2.42% 0.5536 5.69% 5.6% 5 Embotelladora Andina 3,658 2.42% 0.2006 5.69% 3.6% 6 National Beverage 2,739 2.42% 0.5781 5.69% 5.7% 7 Cott 1,566 2.42% 0.5236 5.69% 5.4%

source:ycharts

• Beverages are considered to be defensive stocks which primarily means that they do not change much with the market and are not prone to the market cycles. This is evident from Beta’s of Beverages Companies that are much lower than 1.
• Beverage companies have cost of equity in the range of 3.6% – 6.8%
• Coca-Cola has a cost of equity of 6.4%, while its competitor PepsiCo has a cost of equity of 5.5%.

## Limitations of Cost of Equity

There are couple of limitations we need to consider –

• First, the growth rate can always be estimated by the investor. The investor only can estimate what the dividend appreciation was in the previous year (if any) and then can assume that the growth would be similar in the next year.
• In the case of CAPM, for an investor, it’s not always easy to calculate the market return and beta.

## In the final analysis

The cost of equity is a great measure for an investor to understand whether to invest into a company or not. But instead of looking at just this, if they look at WACC (Weighted Average Cost of Capital) that would give them a holistic picture as the cost of debt also affects the dividend payment for shareholders.

The post Cost of Equity | Formula | CAPM & Dividend Growth Model appeared first on Free Investment Banking Tutorials | WallStreetMojo.

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