What is Cost of Equity ? - Meaning and Concept
Theoretical Concept
The cost of equity concept is very important when it comes to valuing shares on the stock market. Equity, like all other investment classes expects a compensation to be paid to its investors. The problem however is that unlike debt and other classes the cost of equity is never really straightforward. You can look at the interest rates that you are paying and you will straight away know what the cost of debt for your company is. However, the cost of equity is implied. Equity holders take the residual value that has been left from the profits. So it is not directly available.
However, for valuation purposes, the cost of equity is required. Without having the cost of equity and adding it to the discount rate, we will use a lower discount rate that does not reflect the riskiness of the investment. This may lead to selection of the wrong investments. So, this article provides a basis about how we can calculate the cost of equity.
There are two methods to calculating the cost of equity. One is the method that we are about to discuss now and the other is called the “Capital Asset Pricing Model”. That will be discussed in a later article in the same module.
Assumes Market Price Is Correct:
In this method, we will begin with the assumption that the market price is correct. Now, we already know that the market price is nothing but the discounted value of all the future dividends that the company will pay, we can consider the market price to be the value of a perpetuity. Using the perpetuity formula, we can then express the market price as:
Market Price = Dividend (Next Year) / Discount Rate
Growing Perpetuity:
However in a perpetuity the payments remain the same throughout the life of the asset. So by using this formula, we are making the assumption that the dividends paid out across the life of the stock will be the same. Now, we know for sure that is not the case. In reality, the dividends usually grow over time. So we can use the formula for a growing perpetuity. That should give us a better approximation.
Market Price = Dividend (Next Year) / (Discount Rate – Growth Rate)
Rearrange The Formula:
So, now we can re-arrange this formula and solve for the discount rate. The discount rate is our cost of capital and it will be the output from the rearranged formula.
Discount Rate = {Dividend (Next Year) / Market Price} + Growth Rate
So, here it is! We have derived a formula which tells us an estimate of what is the cost of equity that is being demanded from this company by the market.
Estimating the Growth Rate:
Since growth rate is an important component of this formula, we need to ensure that we are using the correct growth rate. We can conduct this estimation in a couple of ways.
- Firstly, we could just calculate what the growth rate has been in the past. We can understand the trend and then use the same growth rate assuming that what happened in the past will continue in the future.
- Alternatively, we could make a more educated guess. The growth rate of dividend next year is dependent on the amount that we invest in the business this year and the rate of return we should earn on that investment right. So growth rate can be derived by using this formula:
Growth Rate = Plowback Ratio * ROE
Plowback ratio is the amount that the company expects to retain in the business whereas ROE is the return on equity that the company historically earns on its equity investments.
It may seem a little complex and full of formulas at the beginning. But there really is just one formula. Other formulas are used to derive the components that will be used in that single formula. So calculating the Cost of Equity that is being implied by the market price shouldn’t really be that difficult.
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