Private equity investors are always looking to know the return on their investments. To know the returns, one of the key inputs is the cost of equity. While one can use a standard formula to determine it, doing that is too time-consuming. A lot of startups can’t afford that amount of time. Luckily, private equity investors can use a calculator to determine their cost of equity in no time. This is where the cost of equity calculator comes in handy!
This tool uses a financial formula to help estimate the cost of equity (also known as the required rate of return) for a company. This type of cost is used by corporations and investors to estimate the required rate of return. It is one of the most important components in the framework to measure a company’s value. The cost of equity is the discount rate that should be used in the present value analysis of a company’s cash flows.
In this article, we will check the formula for estimating the cost of equity and explain what it is and how it is used. That will help you understand the financial aspects of this cost. This can result in better deals for online sellers and vendors. Let’s dig a bit further!
What Is Equity?
First things first, you should understand what equity is and go from there. So, what does it mean?
Equity is a financial instrument that represents ownership in a company. This is what separates it from assets and liabilities. It can be classified as either common stock or preferred stock. Common stock entitles the holder to share in the profits of the company, while preferred stockholders are entitled only to their share of the company’s dividends.
Every company has equity. Equity can be in the form of common stock, preferred stock, or convertible debt. The difference between assets and liabilities is that assets are things of value that a company owns while liabilities are debts owed by the business to others such as suppliers, employees, banks, etc.
Now that you know the basic facts about equity, continue scrolling to find out more about the cost of equity.
What Is Cost of Equity?
In finance, the cost of equity is the rate of return on a company’s common stock that a company needs to generate to satisfy its investors. It is also called the required rate of return. This is calculated by taking the risk-free interest rate and adding a risk premium.
The cost of equity is the return investors require in order to invest their money. It is a measure of what an investor expects to earn from an investment, given the risk involved. An individual’s cost of equity is determined by his or her risk tolerance and time horizon. The higher the risk tolerance and the shorter the time horizon, the higher the required rate of return will be.
What Does Cost of Equity Tell You?
Cost of equity can tell you about returning cash – the money invested in a business or company – to shareholders. This is required when you want to possess shares. Think of it as compensation, as you will have to take on the risk associated with this kind of activity.
Another purpose of the cost of equity is that it allows you to estimate the risk and attractiveness of your investments. The lower the risk, the lower the cost. On the other hand, if the risk increases over time, the cost of equity will be higher.
Cost of Equity: How to Calculate It?
When estimating the cost of equity, there are 2 main methods to get this value. They are both determined by the dividend policy of the company, and each of which depends on whether or not the return is shared with shareholders.
If the firm doesn’t pay dividends, then you need to use the Capital Asset Pricing Model (CAPM). The dividend discount model (DDM) is used for calculating the cost of equity when the company pays dividends. We will check both methods in the section below.
Dividend Discount Model & Cost of Equity
The dividend discount model is a method of valuation that calculates the value of a firm’s stock by discounting the expected dividends, or cash flows, from the firm’s assets. This model is a popular way to value stocks because it provides an estimate of a company’s current worth. It can be used to compare stocks and determine which one has more value.
If you calculate the cost of equity using this model, then you will need the following:
- Dividend per share (DPS)
- Current market value (CMV), and
- The growth rate of dividend (GRD)
Capital Asset Pricing Model (CAPM)
The Capital Asset Pricing Model (CAPM) is a model used in finance to determine the expected return of an asset given its risk. The CAPM is the foundation for modern portfolio theory and is used extensively in financial analysis. It was created by William Sharpe and John Lintner in the 1960s.
If you need to calculate the cost of equity using this model, then you will need the following inputs:
- The risk-free rate of return
- The market rate of return, and
- Beta coefficient
The Formulas for Cost of Equity
Capital Asset Pricing Model (CAPM)
When it comes to the CAMP model, the following formula should be used:
Cost of Equity = Risk-Free Rate of Return + Beta * (Market Rate of Return – Risk-Free Rate of Return)
Example
- Risk-free Interest Rate: 2.00%
- Market risk of Investment (Beta): 0.47
- Market Rate of Return: 10.00%
If we put these numbers in the formula, we’ll get that the cost of equity is 5.76%. Here’s what the calculation looks like: Cost of Equity = 0.02 + 0.47 * (0.1 – 0.02) = 0.0576 *100% = 5.76%.Dividend Discount Model (DDM)
The dividend capitalization model uses the formula below:
Cost of Equity = (DPS / CMV) + GRD
Where
- DPS is the dividend per share
- CMV is the current market value
- GRD is the growth rate of dividend