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What is the Cost of Equity?

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Used in a sentence

The Daily Ledger · Markets

Analysts put the company's cost of equity near 11%, well above the 5% it pays on its bonds.

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Overview

The cost of equity is the yearly return a company's shareholders require for holding its shares, given the risk. No contract states it, but the cost is real: shareholders expect dividends and share price growth, and they move their money elsewhere when a company does not deliver. It runs higher than the interest on the company's debt. In a failure, shareholders get paid last and can end up with nothing. Free-looking money, priced by expectation.
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Overview

The cost of equity is what shareholders demand for owning a company's shares, and it is the priciest money a company uses. No invoice ever arrives. The invoice is invisible: deliver the dividends and the growth, or watch the shareholders leave and take the share price with them. Debt costs whatever the loan agreement says. Equity costs whatever it takes to keep the owners from walking. 😎

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Detail

The cost of equity is the return a company's shareholders require, per year, for the risk of owning its shares. It is one number seen from two sides. To the shareholder it is the return that makes holding the stock worth it; to the company it is the price of using shareholders' money instead of a lender's. It runs higher than the cost of debt because of where each stands if the company fails. Bankruptcy rules pay lenders first, and shareholders collect whatever remains, which can be nothing. Since no contract states the rate, it has to be estimated. The standard tool is CAPM, the capital asset pricing model, and its logic is plain. Start from the return on a safe investment, such as a government bond. Then add extra for taking the stock's risk, scaled by how sharply the stock swings compared with the market. A steady utility earns a small top-up and a volatile young company a large one. The estimate becomes the equity half of WACC, the average rate a company pays for all its money.
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Detail

The cost of equity is what shareholders charge for their money, and they charge more than any bank. The bank sends a bill and the shareholders send nothing, yet the shareholders charge more. The reason is the payout queue when a company goes under. Bankruptcy rules put the bank at the front and shareholders at the very back, where the payout is whatever is left, and sometimes that is zero. Standing at the back is a service, and the back charges for it. Standing there costs extra. Since nobody signs a rate, the number gets estimated, usually with CAPM. The recipe: take what a boring government bond pays, then stack a premium on top for the stock's risk, sized by how wildly the stock swings when the market moves. A sleepy utility gets a small premium. A biotech with one product still in trials gets a big one, priced for the chance the one product stays in trials. 😎

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Analogy

Two job offers. One is a salaried position at a stable employer, the pay modest and certain. The other is a startup role paying partly in a bonus that arrives only if the year goes well. Nobody takes the second job for the first job's pay. To sign, you demand a bigger number, enough to make the gamble worth it, and the shakier the startup looks, the bigger the number you name. A shareholder makes the same demand with money instead of labour. The safe job is the safe investment, and the shares are the startup job. The whole return it takes for a shareholder to choose the shares is the company's cost of equity, and the shakier the company, the higher it runs.
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Analogy

Your cousin opens a coffee cart and offers you a quarter of the profits for a thousand dollars in. There is no promised payback and no rate. If the cart flops, the supplier and the guy who leased him the machine get paid from whatever is left, and you get what remains after them, which is likely nothing. So you do the maths out loud: the bank would pay you four percent for doing nothing, and this is a coffee cart run by your cousin. You want the prospect of a lot more than four before you hand the money over. The full return it takes to get you in, well above the bank's four, is the cart's cost of equity. 😎
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AI explanations may contain errors · Not professional advice

Formal definition — The same term, explained the usual way

The cost of equity is the rate of return required by holders of a company's ordinary shares as compensation for bearing the residual risk of ownership. It is not contractually stated and must be estimated, most commonly by means of the capital asset pricing model, under which the required return equals the risk-free rate plus the equity market risk premium scaled by the security's beta, being the sensitivity of its returns to those of the market. The cost of equity exceeds the cost of debt for the same issuer, reflecting the subordination of equity claims, and constitutes the equity component of the weighted average cost of capital (WACC). It serves as the discount rate applicable to cash flows attributable to equity holders.

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