Considering building a second location, purchasing a company, or entering a new market? Calculating the cost of equity can 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. It's not a straightforward calculation either. Miscalculations can cause you to miss valuable opportunities or take on unprofitable projects. When in doubt, work with a financial and business valuation expert.
The information in this guide can help you 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 it's resilient or volatile, when the market gains or loses value.
- Expected market rate of return: The average 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.
[Read more: 4 Financial Forecasting Models for Small Businesses]
A high cost of equity indicates that shareholders require a greater return on their investment due to perceived higher risks associated with the company's operations or industry.
Who uses the cost of equity metric?
The cost of equity is a useful metric for investors assessing potential returns, companies making financing decisions, and analysts performing valuations. Cost of equity quantifies expected returns relative to risk, which can guide critical financial decisions across different sectors.
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.
It is a similar decision-making process your stakeholders undertake when determining whether to invest in your business. Your stakeholders want to invest in a stock that matches their risk-tolerance level; 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.
Three methods for calculating the cost of equity
There are three formulas for calculating the cost of equity:
Capital asset pricing model (CAPM).
Dividend capitalization.
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, the current stock market value, and the 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.
The capital asset pricing model is slightly more complicated. You need your beta, Rf rate, and EMRP to calculate the CAPM. The formula for CAPM is Expected return = Rf + Βeta × (Rm - Rf), where Rm is the expected return of the market.
Regarding CAPM, the Corporate Finance Institute states that "low-beta stocks are less risky and fetch lower returns than high-beta stocks." Investopedia says that 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."
Companies with multiple forms of equity may use the WACE equation. It looks at stock prices, retained earnings, and equity distribution. This approach is even more complex, and you may prefer to work with a professional.
[Read more: Do You Need Financial Projection Software?]
Comparing the cost of equity with other costs of capital
The cost of equity is often confused with the cost of capital. Cost of capital represents the minimum return a company must earn on its investments to satisfy its investors and cover its financing costs. It encompasses both debt and equity financing — meaning, the cost of equity is a component of the cost of capital metric.
Cost of capital consists of the following three key metrics:
- Cost of equity.
- Cost of debt, or the rate that a company pays on its loans and bonds.
- Weighted average cost of capital (WACC), the combined costs of debt and equity, weighted by their respective proportions in the company's capital structure.
Ultimately, the cost of capital tells investors and business owners how much it costs for the company to raise money either by selling shares or borrowing.
"The cost of equity tends to be higher than the cost of debt. This is because equity investors are rewarded more generously than debtholders, and take higher levels of risks. In addition, debt provides a guaranteed level of payments, and debtholders are given priority in the event of bankruptcy," wrote Investopedia.
How to apply the cost of equity in investment decisions
Cost of equity is a key piece of information that can help investors make more informed decisions. This metric tells potential investors whether a stock or capital project carries a risk that's aligned with the projected returns.
A high cost of equity indicates that shareholders require a greater return on their investment due to perceived higher risks associated with the company's operations or industry. An investor who sees a high cost of equity may be more selective in their investment choices. They might prioritize projects with higher expected returns to justify the elevated costs and ensure they can recoup their investment.
This article was originally written by Jessica Elliott.
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