Required rate of return demanded by equity investors.
cost_of_equityAlso: ReCost of Equity represents the return that equity investors require to compensate for the risk of investing in a particular company. It is typically calculated using the Capital Asset Pricing Model (CAPM), which relates expected return to systematic (market) risk measured by beta.
Cost of Equity is a key input to WACC and directly affects enterprise value. Higher risk companies have higher cost of equity, reducing valuation.
Risk-free rate plus beta times equity risk premium.
= Rf + ERP + Size_Premium + Company_Specific_RiskFor private companies or when beta is unreliable
= Rf + β_m(Rm - Rf) + β_s(SMB) + β_v(HML)Academic or sophisticated institutional analysis
Use 10-year or 20-year government bond yield for risk-free rate. Beta should be levered to reflect company's capital structure. ERP typically 4-6% for US equities.
Cost of Equity is the return investors expect for taking the risk of owning stock. Riskier companies must offer higher expected returns.
CAPM is the standard approach. Master the three inputs: risk-free rate, beta, and equity risk premium. Each requires careful sourcing.
Consider size premium for small caps and company-specific risk for private companies. Build-up method may be more appropriate than CAPM in some cases.
This variable is a key driver in the following financial models: