Cost of Equity is defined as the annualized rate of return (%) that investors must achieve on their investments in shares of companies or mutual funds. Those returns can be composed of annual dividend payments, capital appreciation in the value of the shares, special one time distributions, etc. As a simple example, if an investors buys shares of Apple Inc (AAPL) at $318 per share and expects a return of 10% annualized, then the shares must appreciate by $31.80 in that year and/or Apple pays dividends of that value. The returns that are expected from cost of equity are future expected returns, not historical performances. These expected future returns compensate investors for taking risk to invest in those shares plus the opportunity cost of not investing elsewhere. To calculate cost of equity, we need 3 pieces of relevant data:
- Current fair market value (FMV) of Common shares
- Dividend growth rate
- Dividends per share (in $ or cents)
As an example, let's use the stock symbol PG (Procter & Gamble company) that is trading at $63.40 as of October 25th, 2010 close. Here is the relevant data:
- Next Year's Dividend = $1.93 / share
- Dividend Growth Rate = 9%
- Current Price per Share = $63.40
- Cost of Equity = ($1.93 / $63.40) + 0.09
- Cost of Equity = 0.03 + 0.09
- Cost of Equity = 0.12 or 12%
By investing in the shares of Procter & Gamble, investors & stakeholders would require a 12% rate of return to make their investment worthwhile. It doesn't matter if this 12% return comes from solely dividend payments or capital appreciation or both. Cost of Equity is also known as shareholder's return requirement and involves the computation of the present value of future expected dividend payments. For this reason, it is very difficult to accurately compute the cost of equity because:
i) It is hard to estimate future expected dividend payments
do not know for sure if the company will pay dividends next year or be forced to cut.
iii) The company's earnings growth cannot be accurately forecasted, it always varies quarter to quarter.
There are other more advanced methods that also compute the cost of equity. Examples include the Weighted Average Cost of Capital (WACC) & Capital Asset Pricing Model.
What Drives the Cost of Equity?
A corporation's cost of equity is influenced by several factors including those at the company level and those on the macro-economic level. The more these variables increase uncertainty & risk of investors who are invested in these companies, the higher the returns they will demand. This leads to a higher cost of equity for that company. The following are some factors that affect a company's cost of equity:
i) Company Size - The larger the company in terms of market capitalization, # of employees and offices, the lower the perceived risk of default, thus leading to a lower cost of equity.
ii) Financial Leverage - An increase in corporate debt or financial leverage, the higher the risk of default, thus leaing to a higher cost of equity.
iii) Corporate Taxes - Corporate taxes have a negative effect on cost of equity because since interest payments made on corporate debt are tax deductible, they have a positive effect on lowering corporate taxes. This lowering of taxes will set aside more money to be paid to creditors, thus leading to lower cost of equity.
iv) Liquidity of Stocks - Investors see less risk investing in shares of companies that are highly liquid meaning they have millions of shares (large volumes) trading each day. The transaction costs of buying/selling shares are lower for more liquid stocks, hence lowering the cost of equity.
v) Earnings Forecasts - Analysts who lower a firm's earnings forecasts will increase its cost of equity because investors will be worried about lower earnings/sales which would lead to a decline in stock prices.