Cost of Equity
Candlefocus EditorThe Dividend Capitalization Model uses actual dividends paid by a company to calculate the expected return from owning a share of that company’s equity. Companies with a regular dividend policy are the most suitable for this model as the actual dividend payments are easy to determine. To calculate the cost of equity with this model, one would multiply the current dividend per share (DPS) by the company’s current dividend yield (the ratio of the DPS to the company’s stock price). However, this method is only a good option in the presence of regular dividend payments and when the current dividend yield is relatively stable. If a company’s dividend policy changes over time or if the dividend yield is volatile, this model can undervalue or overvalue the cost of equity.
Alternatively, the CAPM is a more sophisticated and widely used model to determine the cost of equity. This model uses the company’s required rate of return (Rf) to determine the cost of equity, which is the return an investor would expect for buying a share of the company’s stock. This required rate of return is calculated by adding the risk free rate of return, the market risk premium, and beta (a measure of volatility, or risk of the individual stock relative to the market).
The CAPM is a more comprehensive and accurate model for calculating the cost of equity, since it takes into account both individual and market risk and allows for calculation of the cost of equity even in the absence of dividend payments.
Ultimately, the cost of equity provides long-term and short-term investors with a benchmark for evaluating the market value of investments. Companies often compare the cost of equity to the cost of debt when considering strategic maneuvers to raise additional capital. As a result, it is an important measure of how much return an investor can expect from investing in a particular company.