Cost of Equity
The cost of equity represents the annual return expected the equity owners in a business in exchange for the capital they invested. This can also apply to specific projects or investments that aren’t shares of equity in a company.
Cost of Equity
The cost of equity is one of the two components of your company’s capital structure, with the cost of debt being the other. It plays a major role in determining your company’s weighted average cost of capital (WACC), which is commonly used as the discount rate in net present value (NPV) analysis of potential investment decisions such as a new product line, facilities expansion, or an acquisition.
Key Discussion Points:
The cost of equity is a critical component of a company's capital structure, influencing the weighted average cost of capital (WACC) and serving as a key rate in NPV analyses for investment decisions.
A higher cost of equity increases the discount rate, reducing the present value of future cash flows and affecting the intrinsic valuation of a company.
The cost of equity can be determined using the Capital Asset Pricing Model (CAPM), which considers the risk-free rate, beta, and market risk premium, or the Dividend Discount Model (DDM) for companies paying dividends.
Understanding the cost of equity enables business owners to make informed decisions about investments, financing options, and risk management, optimizing the company's capital structure.
Calculating the cost of equity involves challenges such as estimating growth rates and beta, the impact of changing market conditions, and the assumptions of constant growth in DDM, necessitating regular updates and a comprehensive view of financial strategies.
This article delves deep into the concept of the cost of equity, shedding light on the factors that sway it, its central role in the calculation of the weighted average cost of capital (WACC), how to calculate the cost of equity with an example, and the broader considerations that businesses must take into account.
Defining Cost of Equity
The cost of equity is crucial to understand as an SMB owner or entrepreneur. The cost of equity represents the annual return expected by the equity owners in a business in exchange for the capital they invested. This can also apply to specific projects or investments that aren’t shares of equity in a company. Knowing your company’s cost of equity gives you a greater ability to analyze potential investments, identify strategic financing options that optimize your company’s capital structure, and assess risk.
How does one determine the cost of equity? There are two common approaches:
Capital Asset Pricing Model (CAPM): This formula considers multiple factors including the risk-free rate of return, the beta of the company which measures its volatility relative to the market, and the market risk premium which is the excess return that investors require for choosing a risky investment over a risk-free one. If you’re not well versed in finance, this can be an intimidating formula but we’ll define everything and break it down for you in this article.
Dividend Discount Model (DDM): This method will be far less common for SMB owners and entrepreneurs as it pertains to companies that are paying dividends. This model calculates the cost of equity by dividing the annual dividends per share by the current market value per share and adding the dividend growth rate. While there are many private companies that pay dividends, this will be a much more common approach for publicly traded companies. We’ll still cover the formula so you’ll be armed with both approaches.
For businesses, understanding and accurately estimating the cost of equity is a valuable endeavor. It impacts a multitude of financial decisions, ranging from capital budgeting and project valuation to determining the optimal capital structure. As mentioned earlier, it is a key factor in the weighted average cost of capital (WACC), used to assess the financial viability of investment projects and overall corporate strategies.
Associated Terms and Concepts
The list of terms and concepts below will help enhance your understanding of cost of equity before we get into the details of the actual calculations. These terms and concepts are critical to comprehending the significance cost of equity has on your company.
Beta (β): Beta measures a stock's volatility compared to the overall market. A beta greater than 1 indicates that the stock is more volatile than the market, while a beta less than 1 means it is less volatile. Beta is a critical factor in the Capital Asset Pricing Model (CAPM), used to calculate the cost of equity.
Capital Asset Pricing Model (CAPM): CAPM is a model that describes the relationship between systematic risk and expected return for assets, particularly stocks. It's widely used to estimate the cost of equity, incorporating risk-free rate, beta, and market risk premium.
Cost of Capital: This is the total cost of a company to raise capital, including the cost of equity and the cost of debt. Understanding the cost of capital is essential for making investment decisions and evaluating which type of financing is most cost-effective.
Dividends: These are payments made by a corporation to its shareholder members, usually derived from the company's earnings. The dividend policy of a company can influence its cost of equity, as regular dividends may reduce perceived risk.
Dividend Discount Model (DDM): This model calculates the cost of equity by considering the dividends a company pays out to its shareholders, the current market value of its shares, and the growth rate of its dividends. It's especially useful for companies that pay regular dividends.
Equity Financing: This is the process of raising capital through the sale of shares in the business. Equity financing directly relates to the cost of equity, as investors expect a return on the equity they purchase.
Growth Rate: In the context of the DDM, the growth rate refers to the expected rate at which a company's dividends will increase over time. This rate is crucial for estimating future cash flows and, by extension, the cost of equity.
Market Risk Premium: This is the additional return that investors demand for choosing a risky investment over a risk-free one. It reflects the extra risk associated with investing in the equity market as a whole.
Return on Equity (ROE): ROE measures a company's ability to generate profits from its shareholders' equity. While not a direct component of the cost of equity, it provides insight into how effectively a company uses invested capital, which can influence investor expectations and the cost of equity.
Risk-Free Rate: This is the return on investment with zero risk, typically represented by government bonds. The risk-free rate is a component in calculating the cost of equity, serving as the baseline return that investors expect.
Systematic Risk: This refers to the risk inherent to the entire market or market segment, which cannot be mitigated through diversification. Systematic risk is a key consideration in the CAPM and affects the cost of equity.
Becoming familiar with these terms will improve your understanding of the factors that influence the cost of equity and how it impacts your business, leading to more informed strategic decisions about investment opportunities and financing decisions.
Calculating Cost of Equity
For small and medium-sized business (SMB) owners and entrepreneurs unfamiliar with financial concepts, calculating the cost of equity using either the capital asset pricing model (CAPM) or the dividend discount model (DDM) can seem daunting. However, understanding these calculations is crucial for making informed decisions about financing and investments. Below we’ll breakdown both formulas and provide an example calculation to illustrate how these work in practice.
Capital Asset Pricing Model (CAPM) Formula
The CAPM is a model that helps determine the expected return on equity, considering the risk-free rate, the beta (β) of the investment, and the expected market return. The formula for CAPM is:
In the above formula, we have the following variables:
Beta (β): Beta measures the volatility of an asset compared to the market. A beta of 1 means the asset moves with the market, a beta greater than 1 means the asset is more volatile than the market and a beta less than 1 means the asset is less volatile than the market. We have an article dedicated to calculating the beta for small businesses if you need guidance there.
Market Return: This is the estimated returns of the overall stock market. This number can be easily obtained by measuring the historical returns of a broad market index, such as the S&P 500. Over the past 65 years, which includes several stock market cycles (bull and bear markets), the average annual return is between 7% and 8% after the effects of inflation. Either of these numbers will be accepted as the market return. To be more conservative, use the 8% market rate of return which will lead to a higher cost of equity than 7%.
Market Risk Premium: Market risk premium is represented above by (Market Return - Risk-Free Rate). The market risk premium is the additional return that investors expect from investing in markets that involve risk compared to a risk-free investment. As an example, if the market return is 8% and the risk-free rate is 3% then the market risk premium would be 5%.
Risk-Free Rate: The risk-free rate is intended to represent the expected return on a zero-risk investment. Typically US treasury bonds are used as a proxy for the risk-free rate since they’re backed by the government’s credit. When choosing a risk-free rate, be sure to choose a bond that aligns with your investment timeline. If you plan to be invested in perpetuity, the 20 or 30-year treasury bond is a good proxy to use. If you plan to exit after 5 or 10 years, you should use those bond rates instead. If your company has a beta greater than 1, a lower risk-free rate is more conservative and will lead to a higher cost of equity.
Practical Application
Let's walk through a detailed example of how a business owner would calculate the cost of equity for their business using CAPM. Assume the following financial data for this business:
Beta (β): 2.3 based on public company data with an upward revision to account for the risk of a smaller company, indicating the business is 130% more volatile than the market
Market Return: 8% based on the historical return of the S&P 500
Risk-Free Rate: 4% based on current 10-year US treasury bonds as of the date of writing
Utilizing the CAPM formula, we can follow the classic PEMDAS rules to solve for the cost of equity.
In this example, the cost of equity is 13.2%. This means, from an investor's perspective, investing in this business’ equity should yield at least a 13.2% annual return to compensate for the risk compared to a risk-free investment.
CAPM Considerations and Limitations
While CAPM provides a useful framework, it remains subjective as different investors and owners will have different opinions about the level of risk associated with a specific company. As a result of this subjectivity and the inherent assumptions of the formula, there are some considerations to keep in mind:
Beta Accuracy: For many SMB owners and entrepreneurs calculating an accurate beta can be challenging; it may be difficult to decide on the appropriate level of additional risk associated with your company based on its size versus a publicly traded company.
Market Return Assumptions: The expected market return is based on historical data, which may not predict future performance accurately.
Changing Market Conditions: Both the risk-free rate and market conditions can change, affecting the cost of equity.
With all of this in mind, it’s important to recalculate the cost of equity for your company annually.
Dividend Discount Model (DDM) Formula
The dividend discount Model (DDM) is a method used to estimate the cost of equity by considering the dividends a company pays out to equity investors. This model is particularly useful for businesses that provide regular dividends. It's based on the premise that the value of a company is the sum of all its future dividend payments, discounted back to their present value.
The DDM calculates the cost of equity by considering the expected dividends per share, the current market value of the shares, and the expected growth rate of dividends. The formula for the DDM is:
In the above formula, we have the following variables:
Current Market Value: For privately owned businesses without publicly traded shares, utilize the latest valuation for your company here. For public companies, or if your company has a defined number of shares, it may be easier to utilize the market value of the share price for the convenience of working with smaller numbers. Whichever approach is taken, it’s important to utilize the same logic for dividends to ensure consistency in the calculation.
Dividends Paid Next Year: This is the estimated amount of dividends to be paid to equity investors in the company over the next year. Again, this should align with the logic used for the current market value. If you utilized your full valuation for the market value, utilize the full amount of expected dividend payments. If you used a share price, utilize dividends per share. Inconsistency here will lead to an incorrect result.
Growth Rate: This is the estimated annual growth rate of future dividend payments. This can be estimated using a combination of historical data and future growth projections.
Practical Application
Let's walk through a detailed example of how a business owner would calculate the cost of equity for their business using CAPM. Assume the same company from our CAPM example had the following data:
Market Value: $10,500,000 based on the latest valuation
Dividends Paid Next Year: $900,000
Dividend Growth Rate: 7% based on historical growth rates and future earnings projections
With this data, we can set up the DDM formula and solve for cost of equity.
In this example, the cost of equity is 15.6%. This means that for the investors, the expected return on their investment in this company’s equity should be at least 15.6% to compensate for the risk. As you can see the two examples we utilized returned two different costs of equity. It’s important to note that the cost of equity is subjective and there is no absolute answer. Examining multiple scenarios and multiple assumptions around growth rates and beta values will help you understand how sensitive the cost of equity is to movements between these variables.
For the business owner, this figure is important for several reasons:
Investment Decisions: When considering new projects or expansions, the expected return should exceed 13.2% to justify the investment from an equity financing standpoint.
Financing Strategy: Understanding the cost of equity helps in deciding whether to pursue equity financing or explore other options like debt financing, which might have a lower cost.
Attracting Investors: Knowing the cost of equity aids in setting realistic expectations for potential investors and can help in structuring attractive investment propositions.
DDM Considerations and Limitations
As was the case with the CAPM above, the dividend discount model is a useful framework with some limitations. When calculating cost of equity using the DDM be sure to keep the following items in mind:
Dividend-Paying Companies: The DDM is most applicable to companies that regularly pay dividends. Many SMBs and growth companies reinvest their profits rather than paying dividends, which can make this model less applicable.
Estimating Growth Rates: Accurately predicting the future growth rate of dividends can be challenging, especially for volatile industries or businesses with irregular earnings.
Market Conditions: The current market value per share can be influenced by market conditions, which may not always reflect the intrinsic value of the company.
Despite these limitations, the DDM remains a useful tool for estimating the cost of equity for dividend-paying companies.
Benefits of Calculating Cost of Equity
Calculating the cost of equity offers several benefits for small business owners and entrepreneurs. Understanding your cost of equity can provide valuable insights into financial planning, investment decisions, and overall business strategy. Here's a comprehensive list of the benefits:
Enhanced Negotiations: With a solid grasp of the cost of equity, business owners are better positioned to negotiate with potential investors, lenders, and partners, using it as a basis for discussing returns and valuation.
Financial Health Monitoring: The cost of equity can serve as an indicator of the financial health and stability of the business, with significant changes prompting a review of financial strategies and operations.
Improved Investor Relations: Regularly calculating and communicating the cost of equity can improve transparency with shareholders and investors, fostering trust and supporting long-term relationships.
Informed Financing Decisions: Knowing the cost of equity helps business owners evaluate the relative costs and benefits of different financing options, such as equity financing versus debt financing, allowing them to choose the most cost-effective method.
Investment Attraction: A clear understanding of the cost of equity can make it easier to attract investors. By demonstrating awareness of the returns required by equity investors, businesses can more effectively communicate their value proposition and growth potential.
Market Positioning: By understanding the cost of equity in relation to competitors and the broader market, businesses can better position themselves in the eyes of potential investors and industry analysts.
Optimal Capital Structure: Understanding the cost of equity is crucial for determining the optimal capital structure—the mix of debt and equity that minimizes the company's overall cost of capital and maximizes its value.
Performance Benchmarking: It provides a benchmark against which to measure the return on equity (ROE) of the business, helping owners assess how well the company is using equity capital to generate profits.
Pricing of New Equity: When issuing new shares, the cost of equity can guide the pricing to ensure it's attractive to investors while minimizing the dilution of existing ownership.
Project Evaluation: The cost of equity serves as a hurdle rate for evaluating the viability of new projects or investments. Only projects expected to exceed this rate should be considered, ensuring that they contribute positively to shareholder value.
Risk Management: Calculating the cost of equity helps in assessing the risk associated with the business from an investor's perspective. A higher cost of equity typically indicates higher perceived risk, prompting strategies to manage and mitigate these risks.
Strategic Planning: Insights gained from understanding the cost of equity can inform long-term strategic planning, helping businesses align their growth strategies with investor expectations and market realities.
Valuation Accuracy: For businesses considering a sale, merger, or acquisition, an accurate cost of equity is essential for determining the fair market value of the company, ensuring that owners receive fair compensation for their equity.
Considerations and Limitations
While the cost of equity is a highly valuable piece of information that can contribute meaningfully to your business growth and success, there are some considerations and limitations to be aware of when it comes to calculating and implementing the cost of equity. Being aware of these things will be very helpful when talking to or negotiating with investors that may have differing opinions of what the cost of equity should be for your company. It will also help you make more informed investment and financing decisions.
Assumption of Constant Growth: DDM assumes dividends grow at a constant rate indefinitely, which may not be realistic for all businesses, especially in fast-changing industries or for startups.
Beta Reliability: For CAPM, finding a reliable beta for SMBs can be challenging, especially if the company is not publicly traded. Proxy betas or industry averages may not accurately reflect the company's risk profile. Fortunately, SMB owners and entrepreneurs can calculate a beta for their company in a few easy steps.
Changing Capital Structure: The cost of equity can be influenced by changes in the company's capital structure, such as varying the mix of debt and equity, which requires constant updating of the calculation.
Diverse Investor Expectations: Investors may have different expectations based on their risk tolerance, investment horizon, and other factors, making it hard to generalize the cost of equity for all potential investors.
Estimation of Inputs: The accuracy of the cost of equity calculation heavily depends on the estimation of inputs such as the risk-free rate, beta (in CAPM), expected market returns, or growth rates (in DDM). Misestimation can lead to inaccurate results.
Interest Rate Sensitivity: The risk-free rate, often based on government bond yields, can be sensitive to monetary policy and economic conditions, leading to fluctuations in the calculated cost of equity.
Neglect of Non-Financial Factors: These models do not account for non-financial factors such as brand value, customer loyalty, or market positioning, which can significantly impact a business's risk profile and valuation.
Overemphasis on Historical Data: Both CAPM and DDM rely heavily on historical data for market returns, growth rates, and other inputs, which may not be indicative of future performance.
Simplification of Reality: Financial models like CAPM and DDM simplify complex market realities and may not capture all factors affecting a business's cost of equity, leading to oversimplification.
Tax Considerations: The impact of taxes on dividends (in DDM) or on overall returns can complicate the calculation, requiring more sophisticated models to account for after-tax costs.
Keeping these in mind you’ll be well-armed to effectively calculate, maintain, and utilize your cost of equity. If calculating the cost of equity is something you would like to do for your business you’ll soon be able to try our capital asset pricing model (CAPM) and dividend discount model (DDM) calculators (under development) or set some time with us to see how we can help you achieve your goals.