Cost of Equity is the return that equity stockholders expect from the company or the rate of return a company pays out to its equity stockholders.
Investors use the Cost of Equity to determine the rate of return they will receive from the stock. It is important for investors to know the Cost of Equity of a stock because it’s the rate that the investors can expect their stocks to grow by.
Companies use the Cost of Equity to assess whether an investment in a project, whether external or internal, is feasible.
There are two sources of finance for a company. A company can finance its activities either through equity or debt. Equity finance is long-term finance for a company while debt finance is short-term.
The cost of debt finance can easily be calculated by finding its related interest charges; however, the Cost of Equity cannot be calculated in the same way.
There are two models to estimate the Cost of Equity of a company’s stock, the Dividend Capitalization Model (DCM) and the Capital Asset Pricing Model (CAPM).
The Dividend Capitalization Model (DCM)
The Dividend Capitalization Model can be used to calculate the Cost of Equity of a company.
As the name suggests, this model is based on dividends paid by the company and, therefore, can only be used for companies that pay out dividends. This model assumes any future cash inflows for investors will be in the form of dividends.
Using the Dividend Capitalization Model, the Cost of Equity can be calculated as:
Cost of Equity = (Dividends per share / Current market price of stock) + Dividend growth rate
In the above formula, calculations are based on future dividends and dividends per share are taken for the next year.
For example, let’s assume a company ABC Co. paid a dividend of $50 last year while its current market price of the stock is $450 and stockholders expect a dividend growth rate of 10%.
To calculate the Cost of Equity of ABC Co., the dividend of last year must be extrapolated for the next year using the growth rate, as, under this method, calculations are based on future dividends.
The dividend expected for next year will be $55 ($50 x (1 + 10%)). The Cost of Equity for ABC Co. can be calculated to 22.22% (($55 / $450) + 10%).
The Dividend Capitalization Model Without Growth
A variant of the Dividend Capitalization Model can also be used if the dividend growth rate of a company cannot be determined.
Under this variant, Cost of Equity can be calculated as:
Cost of Equity = Dividends per share / Current market price of stock
For example, let’s assume a company XYZ Co. paid a dividend of $20 for many years and expects to continue paying dividends at the same level in the future while the current market price of its stock is $150. The Cost of Equity for XYZ Co. will be 13.33% ($20 / $150).
Disadvantages of Dividend Capitalization Model
Although, the Dividend Capitalization Model is widely used by investors to find the Cost of Equity of a company, it has a couple of disadvantages:
- The data used in the model is forecasted and can, therefore, result in inaccuracies. For example, the dividend growth rate and expected future dividends may not the same as estimated and can, therefore, result in an inaccurate Cost of Equity. The current market price of a stock can also sometimes be inaccurate due to rumors about the company’s stocks in the stock market.
- The model does not consider growth in earnings. For example, if a company’s dividend growth rate is 10% while its earnings grow at only 5%, this means the company will face cash flow problems soon, as it is paying dividends at a higher rate than it is earning. The ability of a company to pay dividends, in the long term, depends on its ability to generate earnings.
- The model assumes that dividends grow at a constant rate over time. The model is sensitive to any changes to the dividend growth rate.
The Capital Asset Pricing Model (CAPM)
As mentioned for the Discount Capitalization Model, it can only be used by investors if a company is paying dividends. If the company does not pay dividends, its Cost of Equity can be found using the Capital Asset Pricing Model.
Although CAPM is more complicated to calculate, it is a bit more accurate because it also takes into consideration the systematic risks associated with stocks. CAPM is also a good model to calculate the Cost of Equity for dividend-paying stocks that are riskier.
The formula to calculate the Cost of Equity of a stock using the Capital Asset Pricing Model is:
Cost of Equity = Risk-free rate of return + Beta x (Market rate of return – Risk-free rate of return)
A risk-free rate of return is a theoretical rate of return for stock and based on the assumption that the investment has zero risks. Beta is a measure of the systematic risk of an investment as compared to the market.
If an investment is riskier than average, then its Beta will be greater than 1, if the investment is less risky than average, then its Beta will be less than 1.
For example, let’s consider a company DEF Co. that has a Beta of 1.3. The risk-free rate of return is 5% while the market rate of return on the investment is 13%. The Cost of Equity for DEF Co. using CAPM will be 15.4% (5 + 1.3 x (12 – 5)).
Disadvantages of Capital Asset Pricing Model
The disadvantages of CAPM are that it is based on a number of assumptions, as follows:
- CAPM assumes a perfect capital market. The perfect capital market assumes that all information about stocks is available to investors, that there are a large number of market participants, that there are no transaction costs and taxes, and that all investors are rational and risk-averse.
- CAPM only takes into account the systematic risks involved with a stock and assumes that investors hold diversified market portfolios. It does not take into account the unsystematic risks involved.
- This model only takes into account the level of return as being important. For this model dividends and capital gains made by an investor, on their stocks, are both considered the same.
Conclusion
The Cost of Equity of a stock helps investors determine the rate of return of a stock. Using this data investors can make decisions on which stocks to add to their portfolios.
There are two different models investors can use to determine the Cost of Equity of stock, the Dividend Capitalization Model, and the Capital Asset Price Model.
