Cost of Equity – The Cost of Equity (Ke) 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 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 Ke?

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 Ke

• #2 – Steel Sector Ke

• #3 – Ke- Restaurant Sector

• #4 – Ke- Internet & Content

• #5 – Ke – Beverages

• Limitations of Ke
 • In the final analysis

• WHAT IS COST OF
EQUITY?
Cost of Equity is an important measure for investors who want to invest in 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 Ke. 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 the 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 Ke 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 Ke 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 Ke.

• 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 the 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.

• Ke = Risk-Free Rate of Return + Beta * (Market Rate of Return – Risk-free Rate of

Return)

• Ke = 0.04 + 1 * (0.06 – 0.04) = 0.06 = 6%.

Interpretation of Cost of Equity
The Ke 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 Ke 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 Ke 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 Ke 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.

Ke = (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%

Ke[(A/B)+C] 17%

So, Ke 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 Ke of MNP Company.

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

asset pricing model.

Ke = 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

Ke [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.