Cost of equity

What it means

The cost of equity is the return a company's owners expect for the money they have invested and the business risk they bear. Unlike interest, it does not appear in the accounts, but it is real: if the company does not earn at least that much for its owners, they could invest their money more profitably elsewhere.

Equity is more expensive than debt because owners are paid after creditors and can lose everything if things go wrong, so they require a higher return. Together with the cost of debt, the cost of equity is part of WACC.

It is most often estimated with the CAPM model: the risk-free rate plus the beta coefficient multiplied by the market risk premium. For small and private companies, premiums for size, illiquidity and specific risks are often added.

How it works in practice

In a discounted cash flow business valuation, the cost of equity is used as the discount rate for cash flows to owners, or through WACC for cash flows to the whole firm. A higher cost of equity means a lower company value for the same expected results.

In investment decisions it serves as the minimum required return on projects financed with equity. A project that earns less destroys value for owners even if it is profitable in accounting terms. Comparing it with return on equity shows whether the company creates value.

In a small family business, the cost of equity is often estimated informally from the return the owner could earn on an alternative investment with similar risk. Even such a simple estimate helps with decisions on dividends, reinvesting profit or selling the business.

What to watch out for

The result depends heavily on the inputs. A small change in the risk premium or beta changes the valuation markedly, so inputs must be justified and not adjusted to reach a desired answer. In a valuation it is good practice to show sensitivity to the main assumptions.

CAPM was developed for large listed companies. For small Slovak companies with no market share price, beta has to be derived from comparable firms and premiums added, which increases subjectivity. It is sensible to compare the result with practical experience from transactions.