Cost of Equity

Calculating cost of equity is a little bit more complex – as there is no equivalent to a loan contract in this case. The general formula is deceptively simple:

Cost of equity = Risk free rate of return + Premium expected for risk

‘Risk-free’ in this particular context means government bonds with the longest duration. The real problem is risk premium which is calculated very differently for public and private companies.

For a public company, its risk premium is determined essentially by fluctuations in its stock price. The more volatile is your company’s stock (relative to the stock market, of course), the riskier is your company (no surprises here). There are several ways to measure this volatility (all of them require some form of statistical analysis) which are covered in books (and textbooks) on security analysis.

But you will most likely not have to read this book because if your company is publicly traded, it is usually covered by at least one (and maybe more) securities analyst in a major (or not-so-major) brokerage house. Evaluating cost of your equity is part of analyst’s job, so all you need is to ask him or her about ‘the number’ and how he/she got it (i.e. cost of equity calculation methodology).

If you company is not publicly traded, you will have to use a totally different approach to calculating your cost-of-equity. In this case, you will have to use the following formula:

CoE = RFR + GRP + IRP + CRP,

where RFR is ‘risk-free rate’ (usually 30-year U.S. treasury bond market rate); GRP – country risk premium (spread between longest-term government bond and the U.S. treasury bond); IRP – your industry risk premium (which, actually, might be negative, if an industry in question is less risky than your country in general); and CRP is your company risk premium (which, again, could be negative, but usually is positive).

To estimate IRP (which typically might add up to 5% to your cost of equity), you must analyze the strength, growth and volatility of demand in your industry; intensity of demand and other key industrial factors.

To estimate CRP (which also typically add up to 5% to your cost of equity) you must do a thorough analysis of your corporate risks (covered in the Corporate Risk Management System section of this book).

Therefore, for a typical company in the U.S. and the U.K. with risk-free rate standing at about 3%, we can expect the cost of equity to be equal to about 8% (3% + 2.5% + 2.5%). However, for business ventures and some special cases, you can see much higher costs – to reflect substantially higher business risks.