Considering building a second location, purchasing a company, or entering a new market? Calculating the cost of equity can ensure your investment pays off. Investors and small business owners use the cost of equity metric to compare future cash flows to investment costs and risks. Understanding your company's cost of equity helps you make better-informed decisions and protect your organization's financial health.
However, cost of equity assumptions are subjective, meaning you may get different results depending on the rates used for calculations. Miscalculations can cause you to miss valuable opportunities or take on unprofitable projects. When in doubt, work with a financial and business valuation expert.
The information in this guide can help you understand how to calculate cost of equity for a small business, the factors affecting equity costs, and how using this metric can improve decision-making, financial planning, and your company’s financial health.
Cost of equity: Definition and key financial terms to know
Cost of equity refers to the rate of return investors expect when funding a business through equity financing rather than debt financing. Small business owners use this metric to determine whether raising money through investors is more cost-effective than borrowing through loans or credit lines.
Here are terms you may come across when calculating the cost of equity:
- Small business equity: This figure is the net worth of your business after subtracting total liabilities from total assets.
- Risk-free rate (Rf): The expected rate of return from an investment with a low to no risk of default, such as government securities or U.S. Treasury bonds.
- Beta of investment: The value indicates how a company's stock price typically responds to market changes, whether it's resilient or volatile, when the market gains or loses value.
- Expected market rate of return: The average return investors expect from the stock market based on historical data.
- Equity market risk premium: In equity financing, this term is often used interchangeably with equity risk premium (ERP). It equals the difference between the expected market return and the Rf.
[Read more: Everything You Need to Know About Financial Projections for Your Business]
Who uses the cost of equity metric?
The cost of equity is a crucial metric for small business owners and executives, investors, financial analysts, and business valuators. When financing a business investment, you have two options: go into debt or use your company's equity. Estimating the cost of equity versus the cost of debt helps you decide how to raise capital.
Stakeholders make a similar decision when determining whether to invest in a company. They want a return that correlates with the initial cost and risk.
Using cost of equity in business valuation models can help assess a company’s financial health. Small businesses need accurate business valuations when selling their company or seeking funding. There are several methods that owners can use to calculate how much their business is worth.
A high cost of equity indicates that shareholders require a greater return on their investment due to perceived higher risks associated with the company's operations or industry.
How the cost of equity impacts your investment decisions
After calculating ROI (return on investment) and other performance metrics, let's say you decide to open a second location. The next decision is to fund your project through financing or issuing new equity.
Here’s how calculating the cost of equity guides your decision-making:
- Cost of equity vs. cost of debt: If the cost of equity is higher than the cost of debt, taking out a business loan may be cheaper.
- Risk vs. return: Expansion is riskier when equity costs more because investors demand higher returns. Lower costs suggest a stronger financial position, giving you better access to capital.
- Investor expectations: You can use the cost of equity calculation to set return expectations for investors. If your cost of equity is 10%, you must generate at least a 10% return to meet their demands.
Using cost of equity to evaluate business performance
The cost of equity calculation isn’t just about raising funds; it’s a key performance metric to track your financial efficiency and profitability over time.
Learning how to calculate business profit can help you decide whether your business is earning enough to meet owner or investor expectations.
Consider these examples:
- Use cost of equity as a benchmark to improve financial planning by forecasting a project's expected return before allocating capital.
- Compare your equity and capital costs to assess whether marketing efforts, new equipment, or expansion projects deliver higher returns than what you put into them.
- Analyze financial statements to see if equity returns are higher or lower than expected and adjust strategies as needed.
Three methods for calculating the cost of equity with examples
There are three formulas for calculating the cost of equity: the capital asset pricing model (CAPM), dividend capitalization, and the build-up method. Review the following guidelines and examples to understand the differences between models and how to estimate the cost of equity using each formula.
[Read more: Everything You Need to Know About Financial Projections for Your Business]
Capital asset pricing model
Publicly traded businesses often use the capital asset pricing model to calculate the cost of equity when dividends are unavailable or inconsistent. CAPM estimates the return investors expect based on the company’s exposure to market risk. Private companies can also use CAPM by estimating beta from comparable public businesses or an industry average.
Here’s what you need to know when calculating cost of equity for a private company:
- CAPM formula: Cost of equity = Rf + beta × (expected market return - Rf).
- Estimate a beta value: Use public market data or a financial database, such as Yahoo Finance or Google Finance, to find the beta from a similar public company or an industry average.
Take the example of a private company using a 4% risk-free rate, an estimated beta of 1.2, and a 9% expected market return. The CAPM formula shows that investors would generally expect a 10% annual return for the risk of investing in the business.
- CAPM formula example: Cost of equity = 4% + 1.2 × (9% - 4%) = 10%.
- Subtract Rf from the expected market return (9% - 4% = 5%).
- Multiply the 5% market risk premium by the 1.2 beta (1.2 x 5% = 6%).
- Add the 4% Rf to calculate an estimated cost of equity (6% + 4% = 10%).
Dividend capitalization model
If your company pays regular dividends to shareholders, you may be able to use the dividend capitalization model, also called the dividend growth model (DGM). This method estimates the cost of equity using the expected dividend per share for the coming year, the current value of each share, and the expected dividend growth rate.
- Formula: Cost of equity = (expected dividends per share next year / current share price) + dividend growth rate.
Suppose a company’s shares are valued at $50 each. It expects to pay a $2 dividend next year, and projects it to grow by 3% annually. The formula looks like this: Cost of equity = ($2 / $50) + 3% = 4% + 3% = 7%. Divide the expected $2 dividend by the $50 share value to get 4%. Then add the 3% growth rate for an estimated cost of equity of 7%.
Build-up method for private companies
The build-up method can help private companies estimate the cost of equity when they don’t have a reliable beta value or publicly traded shares. It begins with a Rf rate and adds premiums for investment risks, like the company’s industry or size.
Small business owners may want to work with a financial adviser or valuation professional when using this method.
Here are the factors affecting cost of equity for small businesses:
- Equity risk premium (ERP): This is the additional return that investors expect from stocks versus a risk-free investment. Calculate ERP using reputable valuation datasets or market-return estimates, such as S&P Dow Jones Indices market projections. The formula is ERP = expected market return - risk-free rate.
- Industry risk premium (IRP): This is an adjustment reflecting risks specific to the company’s industry. Estimate risk levels by looking up industry averages or comparing your business to publicly traded companies.
- Size premium (SP): A 3% to 5% small cap premium generally applies to small businesses, according to Aswath Damodaran, Professor of Finance at the Stern School of Business at New York University. It may be required because small companies generally have few resources and greater operating risk compared to larger businesses.
- Company-specific risk (CSR): This is an adjustment for factors such as inconsistent revenue, strong competition, limited management experience, or its reliance on the owner. It generally ranges from 0% to 10% or more.
Put together, the build-up formula is: Cost of equity = Rf + ERP + IRP + SP + CSR. The cost of equity is higher compared to other methods because it covers additional size and company-specific risks.
For example, the cost of equity is 17% for a small manufacturer using a 4% risk-free rate, a 4% equity risk premium, a 4% size premium, and a 3% company-specific risk. The formula looks like this: Cost of equity - 4% + 5% + 1% + 4% + 3% = 17%.
Common mistakes when calculating cost of equity
Getting the cost of equity right helps you make smarter decisions about investments and risk management strategies. However, small business owners often overlook the cost of their own capital, rely on outdated cost of equity estimates, or don’t adjust for changing market conditions.
Owners may also treat all money received from the business as an investment return without separating profit from a reasonable business owner’s salary. Regularly updating your calculations and accounting for your investments can help you avoid these common mistakes.
Comparing the cost of equity with other costs of capital
The cost of equity is only one part of the capital equation. Understanding cost of equity versus cost of debt and the difference between the weighted average cost of equity and the weighted average cost of capital can improve your investment decisions.
In addition to cost of equity, the key components of capital costs include:
- Cost of debt: The interest rate that a company pays on its loans and bonds.
- Weighted average cost of equity: The blended cost of multiple equity sources, like common stock, retained earnings, and preferred stock.
- Weighted average cost of capital: The combined costs of debt and equity financing, weighted by their respective proportions in the company's capital structure.
How to apply the cost of equity in real investment decisions
Cost of equity is a key piece of information that can help investors make more informed decisions. This metric tells potential investors whether a stock or capital project carries a risk that's aligned with the projected returns.
A high cost of equity indicates that shareholders require a greater return on their investment due to perceived higher risks associated with the company's operations or industry. An investor who sees a high cost of equity may be more selective in their investment choices. They might prioritize projects with higher expected returns to justify the elevated costs and ensure they can recoup their investment.
A plain-English example: What cost of equity looks like for a Main Street business
Let’s say that a local bakery owner estimates its cost of equity at 14%. The owner or investors would expect the business to earn about a 14% return, which compensates them for putting their money at risk. The figure is a benchmark for deciding to pursue (or not) an investment.
Now suppose the bakery is looking at investing $50,000. They project a second location to return 10%, whereas they generate an 18% return by selling baked goods in bulk to local grocery stores and cafes.
Based only on cost of equity, the return on a second location falls below the bakery’s 14% benchmark. Expanding wholesale operations may be more attractive with an 18% return.
However, the owner should also consider:
- How the bakery will price its products.
- Differences in financing costs, like credit card processing fees.
- The impact on its cash flow.
- Additional operating expenses for employee pay.
Emily Heaslip contributed to this article.
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