Concept 5: Cost of equity.

In concept 4, towards the end, I gave a hint on what cost of equity is all about. It is the rate of returns expected by an investor. A decision to invest is made only if the current market price of a share is consistent with its likely return.

What is it?

Cost of equity is the rate of return that an investor expects when he invests in a company. This rate of return   has two components-

  • Dividends expected from the investment and
  • Capital appreciation.

For example –let’s assume that an investor expects 15 % return from a stock that pays 3 % dividend yield. That means, the capital appreciation expected by him is 12%.  The total return from that stock will be 12 % + 3% = 15%.

Getting closer

Let’s take a closer look at the above mentioned return of 15%. If the investor has targeted a 15% return, it simply means  that 15% returns is enough for him to compensate for–

  • The risk he takes for investing in stock market
  • The risk he takes for investing in this particular stock  and
  • The return he forgoes on a risk free investment alternative.

Why cost of equity matters

  • An investor would expect his equity investments to grow by at least the cost of equity;
  • Cost of equity can be used as the discount rate to be used in stock valuation models like discounted cash flow or DCF.

In general, Cost of equity can be calculated in two ways. First method is called the dividend growth method or Gordon’s method and the second one is called the CAPM (discussed in concept 4 while discussing risk premium)

Gordon’s method

The traditional method to calculate cost of equity is the dividend capitalization model which is as follows: (also called Dividend growth model)

  • Expected Dividend Per Share / Market Price  +  Expected Growth rate of dividends

The only way to find the expected dividend rate is by relying the past dividend history and also by listening to what the management of the company hints about the future dividend payment. It worth noting here that –

  • One, past history is no guarantee that future results will follow the trend and,
  • Two, the management is often very optimistic about the future prospects of their business. So the expected dividend should be calculated on a conservative mode.

The Gordon’s model assumes that the company has an infinite life, a constant dividend growth rate and a constant rate of return. It also assumes that the company has only equity and retained earnings to finance its business.For example , if the current stock price of a company is Rs 1000, the expected dividend yield for the next period is 3% and the expected growth rate in earnings and dividends in the long term is 10% then cost of equity would be calculated as follows:

  • Cost of equity = Expected Dividend Per Share / Market Price  +  Expected Growth rate of dividends
  • Cost of equity = 3% + 10% = 13%

If the risk free rate is 7%, the equity risk premium would be 6%. The method is simple and straight forward but it does not apply to companies that do not pay dividends.

From Cost of equity to Cost of Capital

In fact this cost of equity is just one part of a concept called ‘cost of capital’. Equity is one part of the capital that the company uses; the other part is called ‘debt’. When you add up the cost of equity and debt, you get the cost of capital.

What’s worth to note is that the proportion of equity and debt content in the capital structure of a company would not be equal. Secondly, the debt portion may carry a cost which is already fixed and the equity portion may carry a cost which depends on the risk-return trade off.

So to bring everything to balance, we compute the overall cost of capital called the weighted average cost of capital. (WACC)

WACC.

Weighted average cost of capital is not an easy measure to compute. It’s the total of-

  • Cost of equity and cost of debt.
  • Cost of equity may have to be calculated using CAPM or any other approach. The cost of debt is pretty straight- it’s the cost that the company is paying for its debt funds. Since the company can deduct the cost of debt from its revenues (interest is an expense) the resultant tax benefit too, has to be taken into account. so the actual cost of debt would be interest paid less the tax savings resulting from the tax-deductible interest payment.
  • Falling interest rates results in a reduction of the WACC while frauds, scams , market speculation and volatility results in investors demanding more to park their funds in equities and therefore would increase the WACC.

WACC as an Investment Tool

WACC is a valuable tool to make investment decisions. The WACC is the minimum rate of return at which a company produces value for its investors. For example, let’s say a company generates a return of 15% and has a WACC of 7%. That means that the company generates a value of 8% (15-7) for investors in that company.

WACC can also be used as the discount rate in discounted cash flow valuation method –  for valuation purposes. Even small changes in WACC may cause significant change in DCF.

I’ll discuss more about DCF method of valuation in later stages

That’s about cost of equity and capital concept.

In our next post , we discuss an important topic on valuation- estimating the EPS growth rate.

You may like these posts:

  1. Concept 4: Risk premium
  2. Concept 2: Book value
  3. Lessons in computing returns – IV Returns from shares.

1 Response to “Concept 5: Cost of equity.”

Ritesh sawarkar

March 18, 2016 at 12:06 pm

Too….good explanation…

Leave a Comment