Cost of Equity
Also known as: CAPM, Required Return on Equity
The cost of equity is the return shareholders require for the risk of owning a company’s stock, commonly estimated with the capital asset pricing model.
The cost of equity is the return that shareholders demand in exchange for the risk of investing in a company’s stock. It is not a cash expense like interest, but an opportunity cost: what investors could earn on an equally risky alternative.
How it is estimated
The most common approach is the capital asset pricing model, which adds a risk-free rate to the company’s beta multiplied by an equity risk premium. The riskier the stock, the higher the cost of equity.
Where it is used
Cost of equity is a building block of the weighted average cost of capital, which in turn is the discount rate in a discounted cash flow. It directly shapes how much future cash flows are worth today.