Meet TechGen, a startup in the tech industry with ambitious expansion plans on the horizon. As they strategize how to fuel their growth, they face a critical decision: how to finance their endeavors while ensuring they can attract investors.
This dilemma leads Sarah, TechGen’s CFO, to delve into the cost of equity — a fundamental metric that assesses the return shareholders expect for investing in the company’s stock, factoring in the inherent risks associated with its operations and industry landscape.
Cost Of Equity Calculator
The calculator has two calculation options: one based on dividends (DDM) and one without dividends (CAPM). The option without dividends is helpful for companies that do not pay dividends or investors who prefer to use other methods to estimate the cost of equity.
To use the calculator, input the company’s beta, risk-free rate, and market return. The calculator then calculates the cost of equity based on the user’s inputs.
Investors can use the cost of equity calculator to determine if a company’s stock is undervalued or overvalued.
If the calculated cost of equity is higher than the company’s current stock price, the stock may be undervalued. Vice versa, if the calculated cost of equity is lower than the company’s current stock price, the stock may be overvalued.
Calculating Cost of Equity
There are three main methods for calculating the cost of equity: the Dividend Discount Model (DDM), the Capital Asset Pricing Model (CAPM), and the Arbitrage Pricing Theory (APT).
Dividend Discount Model (DDM) Formula
The Dividend Discount Model (DDM) calculates the cost of equity for companies that pay dividends.
The formula requires three inputs:
- Dividend per share (DPS)
- Current market value (CMV)
- Dividend growth rate (GRD)
The cost of equity is then calculated as:
Cost of Equity = (Divident per share / Current market value) + Growth RateFor example, if a company has a current market value of $50 and pays a dividend of $2 per share with a growth rate of 3%, the cost of equity using the DDM would be 7% (($2/$50 x 100) + 3%).
Note that we multiply ($2/$50) by 100 to convert to the percentage as 2/50 is 0.04.
Capital Asset Pricing Model (CAPM) Formula
The Capital Asset Pricing Model (CAPM) is a commonly used method to calculate the cost of equity for companies that do not pay dividends.
The formula requires three inputs:
- Risk-free rate of return – the return from investments considered risk-free, such as U.S. Treasury bonds.
- The market rate of return – the average return from a stock market investment.
- Beta coefficient – a measurement of how a company’s shares respond to changes in the market and show how volatile the stock is.
The cost of equity is then calculated as:
Cost of Equity = Risk-Free Rate + Beta x (Market Return - Risk-Free Rate)Arbitrage Pricing Theory (APT)
There is also another way called Arbitrage Pricing Theory (APT). APT is a method of calculating the cost of equity that considers multiple factors that can affect a company’s stock price.
The formula requires multiple inputs, such as macroeconomic, industry-specific, and company-specific variables. The APT model is more complex than the DDM and CAPM models and requires more data inputs.