Cost of Equity
Cost of equity is the return that equity investors require to compensate them for the risk of owning a company's shares, representing the opportunity cost of capital for equity-financed investments.
Unlike debt, equity carries no contractual payment obligation, so there is no observable 'price' analogous to a bond yield. Instead, the cost of equity must be estimated, and the most widely used framework in US practice is the Capital Asset Pricing Model (CAPM). The CAPM formula is: Re = Rf + Beta x (Rm - Rf), where Rf is the risk-free rate (typically the 10-year US Treasury yield), Beta measures the stock's sensitivity to broad market movements, and (Rm - Rf) is the equity risk premium (ERP) — the additional return investors demand for holding equities over risk-free assets.
As a concrete example, suppose the 10-year Treasury yields 4.5%, a company's beta is 1.2, and the long-run ERP is estimated at 5%. Cost of equity = 4.5% + 1.2 x 5% = 10.5%. This means equity investors in this company require roughly 10.5% annual return to hold the stock instead of investing in Treasuries.
Alternative approaches exist. The dividend discount model (DDM) back-solves for the discount rate: Re = D1 / P0 + g, where D1 is the next expected dividend, P0 is the current stock price, and g is the sustainable long-run dividend growth rate. This is more appropriate for mature dividend payers like Coca-Cola or Johnson & Johnson than for growth companies that pay no dividends. The Fama-French multi-factor model adds size and value premia to CAPM for a richer (if more parameter-intensive) estimate.
The cost of equity is always higher than the cost of debt for the same firm because equity is a junior claim — in bankruptcy, equity holders are paid only after all creditors. This subordination demands a premium. For US companies, cost of equity typically ranges from 7% for low-beta utilities to 15% or more for high-beta technology or biotech firms. Because cost of equity is the largest component of WACC for equity-heavy companies, small errors in the beta or ERP assumption ripple through the entire DCF valuation. Analysts frequently run sensitivity tables varying the cost of equity by plus or minus 1-2 percentage points to understand the range of outcomes.
Another use is benchmarking return on equity (ROE) against cost of equity. If a company earns an ROE above its cost of equity, it is creating shareholder value; if ROE falls below, it is destroying value even while reporting positive net income.