Want to build a second location, purchase a company, or enter a new market? Calculate the cost of equity to ensure your investment pays off. Investors and small business owners use the cost of equity metric to compare future cash flows to investment costs and risks. Understanding your company’s cost of equity helps you make better-informed decisions and protect your organization’s financial health.
However, the cost of equity is subjective, meaning you may get different results depending on the rates used for calculations. Also, figuring out your company’s cost of equity can be challenging. Miscalculations can cause you to miss valuable opportunities or take on unprofitable projects. When in doubt, work with a financial and business valuation expert. Use this information to understand what the cost of equity is, how to calculate it, and why you should use it in your business practices.
Cost of equity meaning and financial terms to know
“Cost of equity” refers to the rate of return expected on an investment funded through equity. Investors and business owners use the metric to determine if a project or business investment is worthwhile.
Here are terms you may come across when estimating the cost of equity:
- Small business equity: This figure is what your business is worth after subtracting total liabilities from total assets.
- Risk-free (Rf) rate: The expected rate of return from an investment with a low-to-no risk of default, such as government bonds or U.S. Treasury bills.
- Beta of investment: The value indicates how a company’s stock price typically responds to market changes, whether resilient or volatile when the market gains or loses value.
- Expected market rate of return: The average amount of return from the stock market based on historical data.
- Equity market risk premium (EMRP): This rate equals the difference between the expected market rate and the Rf rate.
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“Cost of equity” refers to the rate of return expected on an investment funded through equity.
Who uses the cost of equity metric?
When financing a business investment, you have two options: go into debt or use your company’s equity. Before deciding, you must ensure that your estimated cash flow covers the endeavor’s cost. Likewise, your stakeholders want to invest in a stock that matches their risk-tolerance level, and the cost of equity affects their return rate.
If a third party invests their money into your business, they want a return that correlates with the initial cost and risk. Therefore, investors and business owners use a company’s cost of equity to make decisions.
Three methods for calculating cost of equity
There are three formulas for calculating the cost of equity: capital asset pricing model (CAPM), dividend capitalization, and weighted average cost of equity (WACE). If your company pays dividends to shareholders, you can use dividend capitalization. This formula factors the dividends per share, current stock market value, and dividend growth rate. Estimate the cost of equity by dividing the annual dividends per share by the current stock price, then add the dividend growth rate.
In comparison, the capital asset pricing model considers the beta of investment, the expected market rate of return, and the Rf rate of return. To figure out the CAPM, you need to find your beta. Corporate Finance Institute states that “low-beta stocks are less risky and fetch lower returns than high-beta stocks.” Investopedia said beta is “a measure of risk: the higher the beta of a company, the higher the expected return should be to compensate for the excess risk caused by volatility.”
CAPM also requires the market risk premium rate, also known as the EMRP. Your market premium equals the expected market rate of return minus the Rf rate. Professionals typically use the yield on three-month U.S. Treasury bills as the Rf rate. Calculate the cost of equity using CAPM by multiplying the beta of investment by the market premium, then add the Rf rate of return.
Companies with multiple forms of equity may use the WACE equation. It looks at stock prices, retained earnings, and equity distribution. This approach is complex, and you may prefer to work with a professional.
[Read more: Do You Need Financial Projection Software?]
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