MSG Team's other articles

9319 Financial and Economic Models used in the Equity and Currency Markets

We often read about how electronic and software based trading is the norm in stock or equity markets as well as currency and other financial markets. Indeed, anyone who is remotely connected with the stock market or for that matter any financial market would know that there are trading systems and trading software that help […]

11005 Reverse Mergers

The profession of investment banking has become quite innovative over the years. Traditionally, raising capital was an expensive as well as time-consuming process. However, over the past few years, investment banks have devised ways to help their clients raise funds. These ways are neither time consuming nor expensive. A reverse merger is one such innovative […]

10919 Regret Aversion Bias

In order to be successful at investing, an investor not only needs to have mastery over their numbers, but they also need to have mastery over their emotions as well. In the past few articles, we have already discussed how emotional biases can lead to suboptimal performance in investing. In this article, we will try […]

10695 Preferred Shares: An Introduction

Whenever the topic of fixed income securities is considered, the obvious assumption many investors make is that the conversation is about bonds. It is true that bonds are the most commonly traded types of fixed-income securities. However, they are not the only type of fixed-income securities. Preferred shares are another common type of fixed income […]

12787 Introduction to Commodities Investing

Ever since the beginning of history, humans have been using commodities. This has created a necessity to trade commodities. However, as financial markets advances, trading commodities became a business unto itself. The modern world provides a plethora of options when it comes to commodities investing. Commercial users of the products can use these financial markets […]

Search with tags

  • No tags available.

Theoretical Concept

The cost of equity concept is very important when it comes to valuing shares on the stock market. Equity, like all other investment classes expects a compensation to be paid to its investors. The problem however is that unlike debt and other classes the cost of equity is never really straightforward. You can look at the interest rates that you are paying and you will straight away know what the cost of debt for your company is. However, the cost of equity is implied. Equity holders take the residual value that has been left from the profits. So it is not directly available.

However, for valuation purposes, the cost of equity is required. Without having the cost of equity and adding it to the discount rate, we will use a lower discount rate that does not reflect the riskiness of the investment. This may lead to selection of the wrong investments. So, this article provides a basis about how we can calculate the cost of equity.

There are two methods to calculating the cost of equity. One is the method that we are about to discuss now and the other is called the “Capital Asset Pricing Model”. That will be discussed in a later article in the same module.

Assumes Market Price Is Correct:

In this method, we will begin with the assumption that the market price is correct. Now, we already know that the market price is nothing but the discounted value of all the future dividends that the company will pay, we can consider the market price to be the value of a perpetuity. Using the perpetuity formula, we can then express the market price as:

Market Price = Dividend (Next Year)/Discount Rate

Growing Perpetuity:

However in a perpetuity the payments remain the same throughout the life of the asset. So by using this formula, we are making the assumption that the dividends paid out across the life of the stock will be the same. Now, we know for sure that is not the case. In reality, the dividends usually grow over time. So we can use the formula for a growing perpetuity. That should give us a better approximation.

Market Price = Dividend (Next Year)/(Discount Rate – Growth Rate)

Rearrange The Formula:

So, now we can re-arrange this formula and solve for the discount rate. The discount rate is our cost of capital and it will be the output from the rearranged formula.

Discount Rate = {Dividend (Next Year)/Market Price} + Growth Rate

So, here it is! We have derived a formula which tells us an estimate of what is the cost of equity that is being demanded from this company by the market.

Estimating the Growth Rate:

Since growth rate is an important component of this formula, we need to ensure that we are using the correct growth rate. We can conduct this estimation in a couple of ways.

  • Firstly, we could just calculate what the growth rate has been in the past. We can understand the trend and then use the same growth rate assuming that what happened in the past will continue in the future.

  • Alternatively, we could make a more educated guess. The growth rate of dividend next year is dependent on the amount that we invest in the business this year and the rate of return we should earn on that investment right. So growth rate can be derived by using this formula:

Growth Rate = Plowback Ratio * ROE

Plowback ratio is the amount that the company expects to retain in the business whereas ROE is the return on equity that the company historically earns on its equity investments.

It may seem a little complex and full of formulas at the beginning. But there really is just one formula. Other formulas are used to derive the components that will be used in that single formula. So calculating the Cost of Equity that is being implied by the market price shouldn’t really be that difficult.

Article Written by

MSG Team

An insightful writer passionate about sharing expertise, trends, and tips, dedicated to inspiring and informing readers through engaging and thoughtful content.

Leave a reply

Your email address will not be published. Required fields are marked *

Related Articles

Cross Border Credit Reporting

MSG Team

What is Corporate Finance? – Meaning and Important Concepts

MSG Team

Compounding Intervals and Interest Rate

MSG Team