Calculate and Interpret the Cost of Equity
The Cost of Equity (COE) is the minimum rate of return shareholders require for their investment in common stock of a corporation. This expected future return to the investor consists of both capital gains (share price appreciation) and dividends. The cost of equity formula helps investors determine the cost of capital which equates the current share price with the discounted value of future dividends from the company in perpetuity. The cost of equity is an input of the Weighted Average Cost of Capital (WACC) to calculate the real cost of capital for a firm using account debt and equity funding.
Calculating the Cost of Equity
The formula for the cost of equity can be written as:
Cost of Equity = ((Dividend for Next Year + Stock Price Appreciation) / Current Share Price)) + Dividend Growth Rate
The data needed to perform the calculation is often included in the company’s financial reports. Investors may also obtain the information through various online sources or through financial analysts.
Utilizing the Cost of Equity Measure
The cost of equity measure provides investors with a relatively simple way to monitor the status of their investment and helps ensure that investment in those shares continues to be a sound strategy.
For individual investors, the COE also reflects the opportunity cost of investment and will differ among companies due to varying levels of risk. A higher cost of equity indicates a higher level of risk. Investors should expect a higher rate of return to compensate for an elevated level of risk.
There are a number of other ways to estimate the cost of equity, including the Capital Asset Pricing Model (CAPM).
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The above information is educational and should not be interpreted as financial advice. For advice that is specific to your circumstances, you should consult a financial or tax advisor.
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