Today, we are going to look at the cost of equity (COE).

The cost of equity is a powerful financial concept and it matters because it is used in valuing companies. But it can also be used by people who run companies, to improve the businesses.

The cost of equity is not often discussed and it certainly does not feature in financial statements, like the cost of debt does. Interest paid is the cost of debt and it is shown on the income statement.

Over the next few editions of this newsletter, we are going to look at how to increase the value of a business, using simple finance concepts. In this edition, we are going to lay down the basic theory on the cost of equity.

Every business owner and investor should know their cost of equity.

In this edition, we will look at:

1. What is the cost of equity?

2. Why you need it?

3. How to calculate it.

What is the cost-of-equity?

Let me ask you a question. If you earn a 5% return, is that good? It is impossible to tell, unless you have something to compare with. For instance if you could have earned 8%, then you are not doing too well. But if everyone only earns 4%, you are doing okay.

The idea of comparing your return to the returns available in the market is the concept of opportunity cost. In other words, what opportunities are you forsaking by being invested in something else?

The cost of equity is an opportunity cost. It aims to measure the return that you should receive to compensate you for the risk that you are taking.

When you hold a stock, it is the minimum return that you want to get for holding that stock.

To wrap your head around it, you can think of it as similar to an interest rate on debt. It is kind of like the interest rate you should get on equity. But remember, in reality, there is no interest rate on equity. This is a conceptual rate.

Why you need it?

You need a cost of equity to do a valuation on a stock. Depending on your valuation method, you may use it directly or as part of the Weighted Average Cost of Capital (WACC).

But business owners can also use it as a benchmark to aid them in decision making, in the normal course of business. We will look at this in more detail in upcoming newsletters.

How do you calculate the cost of equity?

The most commonly used method is the Capital Asset Pricing Model (CAPM).

E(r) = R_F + Beta x [E(rm) – R_F]

• E(r) = cost of equity

• Beta = measure of systematic risk

• R_F = risk free rate

• E(rm) = expected market return

• Market risk premium = E(rm) – R_F

This equation estimates the cost of equity for a stock, using market factors. If your company is listed on a stock exchange, you can get these inputs quite easily. If your company is private, you have to estimate it through comparables.

Beta you get from the stock price movements relative to the market (you can look it up). The risk free rate is normally the yield on a 10-year treasury (government) bond. The market risk premium is the amount that equity earns over risk free bonds. That premium generally ranges between 5% and 7%.

Example:

E(r) = R_F + Beta x [E(rm) – R_F]

E(r) = 4% + (1.1) x (10%-4%)

E(r) = 10.6%

• R_F = 4%

• Beta = 1.1

• E(rm) = 10%

• Market risk premium = 10% - 4% = 6%

In this example the cost of equity = 10.6%.

In other words, the owner of this stock should receive a return of at least 10.6% per annum to be compensated for the risk taken. Higher return is better, lower is worse.

Conclusion:

The cost of equity can also be called the expected return or the required return. You can look up most of the inputs online and plug them into the formula. This will give you a reasonable starting point for the cost of equity in your valuation. Alternatively, if you are using it to measure business performance, it will give you an indicator of the return that you should get on equity.

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