Cost of equity
In one sentenceThe return owners or shareholders expect for investing their money in the business and bearing its risk, used as a rate for discounting cash flows and valuing projects.
Simply put
Owners do not receive a fixed installment, but their money is not free: they could have invested it elsewhere. The cost of equity is the minimum return that satisfies them.
One way to estimate it is the capital asset pricing model (CAPM): the return on a near risk-free investment, plus the market risk premium multiplied by the stock's “beta” sensitivity coefficient.
Worked example
An analyst estimates the cost of equity of a listed company with hypothetical figures for illustration: a near risk-free return of 4%, a market risk premium of 6%, and a stock beta of 1.2.
Stock risk premium1.2 × 6% = 7.2%
Near risk-free return4%
Cost of equity = 4% + 7.2%11.2%
Formula: Risk-free return + beta × market risk premium
Don't confuse it with
Cost of debtA cost written in the financing contract, while the cost of equity is an estimated expectation.