What is equity?

Equity is an ownership stake awarded to investors as shares of your company’s stock. When the current market value of the shares goes up, investors are rewarded with potential returns. A higher market rate of return and future dividends could increase that return. This form of corporate finance is common for startups and businesses in growth mode. 

The amount of equity awarded to investors is determined by a stock price based on the company’s valuation. The amount of the equity investment determines the ownership percentage given to the investor. This can be represented by common stock, which comes with voting rights, or preferred stock with a higher liquidation preference.          

What is the cost of equity?

The cost of equity differs based on the party it's associated with. For the investor, it’s the rate of return required to justify the investment. The company measures it based on the return from using the funds the investor provides. For example, an accelerated growth rate due to increased spending could raise the stock price. That mitigates the cost of equity for the company.

The company’s cost of equity can be higher than the cost of debt because interest payments on debt are tax deductible. Paying dividends on stock increases the cost of equity further. Systematic risk could impact the investor's cost, such as not meeting the expected market return or losses due to the stock’s volatility on a public exchange.      

Variables used to calculate the cost of equity

The cost of equity is used for investment decisions and business financial modeling. Each cost of equity formula uses different variables:

Current market value (CMV)

Equity is awarded to investors as shares of stock. The value of shares on the day they change hands is the current market value when calculating the cost of equity. Private companies set the share price using a business valuation, while public share prices are determined by stock market activity. CMV is also used as the cost basis of the shares for tax purposes.   

Please consult with a tax professional for additional guidance.

Risk-free rate of return (RF)

The risk-free rate of return (RF) is a theoretical number. It’s calculated using the current treasury bill (T-bill) rate or the long-term yield of government bonds. Due to their government backing, these are considered “safe” or “risk-free” investments. Investors are looking for higher returns, but RF is a good number to use as a baseline for cost-of-equity calculations.

Market rate of return (MRR)

MRR is a term used to describe the average rate of return on an investment over a specific period. For instance, the S&P 500 has had an average rate of return of roughly 10% per year since its inception in 1957. Investors can use that number to calculate Beta, which is described below. It’s also useful for measuring the return on investment for the current project.  

Beta (β)

Beta measures a stock’s volatility. It’s a risk factor calculated by comparing the company’s rate of return with the average market rate of return (MRR). The S&P 500 has a Beta of 1.0. Mining and pharmaceutical companies typically have higher Betas, but they also offer higher potential returns for investors. This risk versus reward scenario is common in investing.

Equity risk premium (ERP)

The equity risk premium is the difference between the risk-free rate and the average market rate of return. That “margin” factors into the decision-making for stock market and equity investments. The ERP should match or exceed the required rate of return set by the investor.

Market risk premium (MRP)

This number is useful for investors because it measures the difference between an expected rate of return on your investment and the risk-free rate. If the MRP is negative, you’re better off investing in bonds or looking for equity elsewhere. A positive MRP is a good sign, but make sure the ERP is also positive. That indicates a potential for a good return.   

Dividends per share next year (DPS)

Businesses generally announce dividend distributions before they happen, sometimes several months before the dividends are paid. Certain cost-of-equity calculations require the DPS to work properly. The dividend is entered as a dollar amount in the formula. If a dividend schedule has not been announced, you can use the average dividends paid in past years.

Growth rate of dividends (GRD)

This is another theoretical number because actual growth can’t be measured without knowing how volatile a stock will be after it’s awarded. The best way to get this number is to calculate the average growth rate of dividends from previous years and apply that number to the next year. Remember that this is hypothetical, so it’s only an estimate.

How to calculate the cost of equity

Armed with your new glossary of terms, you should understand the variables used to calculate the cost of equity. You might also want to review your company's current market price and capitalization table. Giving away too much equity, even for a large investment, won’t look good on your financial statements. Plan carefully and calculate the cost. Here’s how:

Cost of equity formula: CAPM model

The capital asset pricing model (CAPM formula) calculates the cost of equity (CoE) by using the risk-free rate of return (RF), the expected market rate of return (MRR) for the next year, and the Beta (β) of the investment. The formula looks like this: 

CoE=RF+β x (MRR - RF)

Apply this formula to the S&P 500, which has a Beta of 1.0 and an MRR of 10%. We can use the average ten-year Treasury return of 4.25% for RF. The equation would be 4.25+1.0 x (10-4.25), which equals 4.25 + (1.0 x 5.75) = a CoE of 10%. Anything over 7% is considered good.

Cost of equity formula: Dividend capitalization model

The dividend capitalization model calculates the cost of equity using the current market value (CMV), dividends per share (DPS), and dividend growth rate (GRD). This formula only works if the company pays dividends, which many do not. Here’s the formula: 

DPS / CMV + GRD

Dividends can significantly increase the rate of return on investment, so if the business pays them out, they must be factored in. Consider this carefully if you’re seeking equity instead of debt financing. The IRS treats dividends differently than interest-rate payments.

Cost of equity and WACC

The weighted average cost of capital (WACC) factors in the cost of equity and the cost of debt to determine whether a company’s capital structure is balanced. Ideally, you’ll want to have a 50/50 mix of equity and debt financing. Assume the cost of equity is 8% and the cost of debt is 4%. If you’re balanced, the WACC will be 6%. This value can be used in cash flow forecasting and planning, financial reporting, and acquiring additional financing.

FAQs about the cost of equity calculation

How do you calculate the cost of equity?

Two common ways to calculate the cost of equity are the capital asset pricing model (CAPM) and the dividend capitalization model (DCM). The CAPM formula uses the risk-free rate of return (RF), the expected market rate of return (MRR) for the next year, and the investment's Beta (β). The DCM model applies to companies paying dividends. It uses the current market value (CMV), dividends per share (DPS), and dividend growth rate (GRD).

What is the difference between the cost of equity and WACC?

The weighted average cost of capital is the average cost of equity and debt financing combined. This number is important for examining a company's capital structure. Ideally, financing should be 50% debt and 50% equity because debt is typically cheaper.    

Is CAPM the same as the cost of equity?

No. The capital asset pricing model (CAPM) is a formula for calculating the cost of equity.   

Is a high cost of equity good?

It can be. 7%- 8% is considered a good cost of equity. Investors view companies with higher CoEs as safer investments, and lenders consider them lower risk. 

Wrap up

The cost of equity (CoE) is an important metric when acquiring financing for your business. It can be calculated using the capital asset pricing model (CAPM) or the dividend capitalization model (DCM). Either way, the CoE factors in, along with the cost of debt, when calculating your weighted average cost of capital (WACC). Be sure to study these concepts if you’re planning on doing a round of fundraising.

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Kevin Flynn is a guest contributor. The views expressed are theirs and do not necessarily reflect the views of Rho.

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