The return shareholders require
Debt has a visible price: the interest rate. Equity does not — shareholders are paid whatever is left. Cost of equity is the return they require for accepting that risk, and it is what a company must beat before it is creating value rather than consuming it.
The formula
Three inputs: the return on government bonds, how volatile the share is relative to the market, and what the market as a whole is expected to return.
Worked example: 4% risk-free, 10% market, beta 1.2
- Market risk premium: 10 − 4 = 6 points
- Adjusted for beta: 1.2 × 6 = 7.2 points
- Cost of equity: 4 + 7.2 = 11.2%
A beta of 1.2 means the share has historically moved 20% more than the market in both directions, so shareholders demand 1.2 points more than the average premium.
What beta does to the answer
| Beta | Interpretation | Cost of equity |
|---|---|---|
| 0.5 | Utility, staple, defensive | 7.0% |
| 1.0 | Moves with the market | 10.0% |
| 1.2 | Somewhat more volatile | 11.2% |
| 1.8 | Cyclical or highly leveraged | 14.8% |
The spread between a defensive and a cyclical business is nearly 8 percentage points. In a discounted cash flow model, that difference roughly halves the valuation of identical cash flows.
Where the model is weak
Beta is measured on past prices and assumes the past describes the future. In a crisis, correlations converge and every beta drifts toward 1, exactly when the distinction mattered.
The market return is also an assumption, usually taken from a long historical average. Two analysts using 8% and 11% will disagree about a company's value by a wide margin while both being defensible.
What this calculator leaves out
Size and country premiums, which practitioners commonly add for small or emerging-market companies. Also the fact that a private company has no observable beta and must borrow one from listed comparables.
What the company does with the number
Cost of equity is not academic; it sets the hurdle rate for investment decisions. A project expected to return 9% destroys value at an 11.2% cost of equity, even though it makes an accounting profit.
It also drives valuation directly. Discounting the same cash flows at 11.2% instead of 10% reduces a perpetuity's value by roughly 11%, and on a growing stream the effect is larger still. Small disagreements about beta produce large disagreements about what a company is worth.
The dividend growth alternative
For a mature dividend payer there is a second route that avoids beta entirely: cost of equity equals dividend yield plus expected dividend growth. A share yielding 4% with dividends growing 5% a year implies a 9% cost of equity.
Where the two methods disagree materially, the disagreement is informative. It usually means either the beta is unrepresentative of the current business or the growth assumption is optimistic, and finding out which is more useful than averaging them.
Related calculators
- CAPM calculator — the same model, framed as an asset return
- WACC calculator — this figure blended with the cost of debt
- Beta calculator — the input this model depends on most