What is cost of equity?
Cost of equity is the return shareholders require for owning a company's stock. A company pays no interest on equity, but investors still expect to be paid for the risk, through dividends and a rising share price. If the company cannot earn at least that return on their money, the shares are worth less than they cost. The short answer is in what cost of equity means.
Companies use it as the hurdle rate for projects funded with equity, as the equity piece of WACC, and as the discount rate when an analyst values the stock from its cash flows or dividends.
- Cost of equity is a percentage per year, written Ke or Re.
- It is an estimate. No document or market quote gives it directly, so the answer depends on the method and inputs you pick.
- Worked example: a 5% risk-free rate, a beta of 1.2 and a 5% equity risk premium give 11%.
Cost of equity formula (CAPM)
cost of equity = risk-free rate + beta x equity risk premium
Ke = Rf + β x (Rm - Rf)
The capital asset pricing model is the formula most analysts reach for first. It starts with what you could earn with no risk, then adds a premium for the market risk the stock carries.
- Risk-free rate (Rf): the yield on a government bond, usually the 10-year or 20-year Treasury. The US Treasury publishes daily yields.
- Beta (β): how much the stock moves with the market. A beta of 1.2 means it tends to move 1.2% when the market moves 1%.
- Equity risk premium (Rm - Rf): the extra return investors expect from stocks over the risk-free rate.
How to calculate cost of equity
Here is the CAPM calculation with the example inputs loaded in the calculator above.
- Take the risk-free rate: 5%.
- Multiply beta by the equity risk premium: 1.2 x 5% = 6%.
- Add the two: 5% + 6% = 11%.
So shareholders in this company want about 11% a year. Each step, and where to find each input, is covered in how to calculate cost of equity using CAPM. If you would rather work in a spreadsheet, cost of equity in Excel gives the cell formulas.
Cost of equity by beta
The table holds the risk-free rate at 5% and shows how beta and the equity risk premium move the result. A beta of 1 earns exactly the market's return. Every 0.1 of beta adds a tenth of the premium.
| Beta | ERP 4% | ERP 5% | ERP 6% |
|---|---|---|---|
| 0.5 | 7% | 7.5% | 8% |
| 0.75 | 8% | 8.75% | 9.5% |
| 1 | 9% | 10% | 11% |
| 1.2 | 9.8% | 11% | 12.2% |
| 1.5 | 11% | 12.5% | 14% |
| 2 | 13% | 15% | 17% |
Not sure which beta to use? Published betas are usually levered, which means they already include the company's debt. Levered vs unlevered beta explains when to adjust one.
Where to find the equity risk premium
This is the input people argue about most. Two widely used US figures: valuation firm Kroll recommends a 5.0% US equity risk premium, paired with the higher of a 3.5% normalized risk-free rate or the spot 20-year Treasury yield. NYU professor Aswath Damodaran's implied premium for the S&P 500 ranged from 4.23% to 6.12% between 2015 and 2025. The calculator starts at 5%. Whatever you choose, use the same figure across every company you compare.
Dividend growth model
cost of equity = next year's dividend / share price + dividend growth rate
Ke = D1 / P + g
The Gordon growth model works backward from the share price. If a $50.00 stock just paid $2.00 a year and the dividend grows 4%, next year's dividend is $2.08. That is a 4.16% yield, and adding the growth rate gives 8.16%. It only suits companies that pay a steady, growing dividend. The dividend growth model guide covers the D0 versus D1 mix-up and when the model breaks.
Cost of equity for a private company
A private company has no share price and no beta, so neither formula above works directly. Valuation analysts use the build-up method instead. It stacks premiums on the risk-free rate: 5% risk-free, 5% equity risk premium, a 3% size premium and a 2% company-specific premium add up to 15%. That higher number is why small businesses sell for lower multiples than public companies. More in cost of equity for a private company.
Cost of equity and WACC
Cost of equity is one input to the weighted average cost of capital. A company funded 60% by equity at 11% and 40% by debt at 6% before a 21% tax rate has a WACC of about 8.5%. Use cost of equity to value the shares alone, and WACC to value the whole business. Cost of equity in WACC walks through the weights, and is cost of equity the same as WACC gives the short version.
Cost of equity vs cost of debt
Equity almost always costs more than debt. Lenders are paid first and get a fixed rate, and the company deducts interest from taxable income. Shareholders are paid last and get no deduction. The comparison, with numbers, is in cost of equity vs cost of debt. Adding debt does push the cost of equity up, because it makes the shares riskier (see does cost of equity increase with debt).
Cost of equity vs return on equity
The two sound alike and get mixed up often. Return on equity is what the company actually earned on its book equity last year, taken from the financial statements. Cost of equity is what shareholders require going forward. A company whose ROE stays above its cost of equity is adding value. See is cost of equity the same as return on equity.