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What is the Cost of Equity?

The cost of equity is the return an investor expects to earn by virtue of holding shares of a company. It is closely related to the risk profile of the company because an investor will expect high returns when holding a risky asset and low returns when holding a relatively safe asset.

The capitalized asset pricing model (CAPM) is an easy way to estimate the cost of equity in a publically traded company.  The model estimates the risk of a company, and by extension the cost of equity, based on the how the stock moves in relation to the market as a whole.

The Capitalized Asset Pricing Model:

Ke = Rf + B(Rm – Rf)

Ke – Cost of Capital

Rf – The Risk Free Rate of Return

The return an investor can achieve with effectively no risk. The rate can be determined by looking at US treasury yields since the risk of the United States defaulting is essentially zero. Use the risk free rate that corresponds with the timeframe used to determine the market rate of return.

Rm – The Market Rate of Return

The long term expected return on a portfolio comprised of every equity in the market. The following table shows the estimated nominal market returns according to Charles Schwab Investment Advisory Inc.:

 

Large Cap US Equities (S&P 500)

7.4%

Mid/Small Cap (Russell 2000)

8.2%

International Equities (MSCI EAFE)

7.2%

 

This is a great source because it is based on up to date market data and all of the assumptions are explained clearly. Remember to use the market rate of return for the same index used to calculate Beta below.

B – Beta

The beta of a stock is a measure of the covariance between the stock’s movement and the movement of the market as a whole.

  • A Beta of 1 indicates that the stock generally follows the market perfectly.
  • A Beta greater than 1 indicates that the stock generally moves with the market but is more volatile
  • A Beta less than 1 indicates either that the stock moves with the market with low volatility or has high volatility but isn’t correlated with the market’s movement.
  • A negative beta indicates that the stock’s movements generally move opposite to the market

However, the Beta is calculated based on market returns which are impacted by the companies capital structure. If the company is highly levered (holds a large amount of debt) equity investors will expect a higher return since the capital structure adds risk.  Since we are using the cost of equity in our WACC calculation we need to determine the unlevered cost of equity. The easiest way to do this is to calculated the unlevered Beta.

Bu = Bl / (1 + (1 – T) * (D/E))

This unlevered beta should theoretically be used to calculate the cost of capital. However, the unlevered beta will always be lower than the levered beta since leverage increases the risk of the equity. In order to be conservative (the CAPM isn’t perfect anyways) you can consider simplifying your calculations and using unlevered beta in calculating the cost of capital.

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