How to estimate the cost of equity for a company

Shareholders do not get a fixed interest rate, but they still expect a return for the risk they take. That expected return is the cost of equity. This page explains what cost of equity means and the two most common ways to estimate it.

Quick answer

Cost of equity is the rate of return that shareholders expect to earn for investing in a company's shares, given the risk involved. It is the company's cost of using shareholders' money. It is usually estimated with the capital asset pricing model (CAPM), using the risk-free rate, the company's beta and the equity risk premium, or with the dividend discount method.

Key takeaways

• It is the return shareholders expect for their risk.
• It is usually higher than the cost of debt.
• CAPM is the most common way to estimate it.
• The dividend growth method is another approach.
• It feeds into WACC and valuation models.

What is cost of equity?

When people invest in shares, they give up the chance to put that money somewhere safer, like a government bond. They also take on the risk that the share may fall. To accept this, they expect a higher return. That expected return is what the company must aim to cover.

It is not a bill the company pays. But if a company earns less than what shareholders expect, its share price may suffer over time, so managers treat it as a real cost.

Method 1: CAPM

The most common formula is: Cost of equity = Risk-free rate + Beta x Equity risk premium. The risk-free rate is often based on the yield of long-term government bonds. Beta measures how much the share moves compared with the market. The equity risk premium is the extra return expected from shares over safe bonds.

These numbers are only for illustration. Each input involves judgement, so different analysts may arrive at different figures for the same company.

Method 2: Dividend growth

For companies that pay steady dividends, another approach is: Cost of equity = (Next year's dividend / Current share price) + Expected dividend growth rate. This comes from the Gordon growth model.

For example, if next year's dividend is Rs 10, the share price is Rs 200 and dividends are expected to grow 7 percent a year, the cost of equity is 5 percent + 7 percent = 12 percent. This method does not work well for companies that pay little or no dividend.

Why it is higher than the cost of debt

Lenders get paid first and often have security. Shareholders get paid only after everyone else and have no promised return. Because they carry more risk, they expect more. Also, interest on debt is tax-deductible, while returns to shareholders are not.

How it is used

This figure is a key input in WACC, in valuing shares through dividend discount models and in judging whether a company's return on equity is adequate. A company whose ROE stays below its cost of equity may not be creating value for shareholders.

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