Cost of Equity
Cost of equity is the rate of return shareholders require in exchange for the risk of owning a company's stock. It is usually estimated with the Capital Asset Pricing Model (CAPM): the risk-free rate plus the stock's beta multiplied by the equity risk premium. It is one of the two building blocks of WACC.
Worked example
With a risk-free rate of 4%, a beta of 1.2, and an equity risk premium of 5%: cost of equity = 4% + 1.2 × 5% = 10%.
Why it matters
Cost of equity is almost always higher than cost of debt, because equity holders are paid last and carry more risk. It is the single largest driver of WACC for most companies, since most firms are majority equity-financed.
Frequently asked questions
Why is cost of equity higher than cost of debt?
Shareholders rank behind lenders if a company fails and their returns are not contractually guaranteed, so they demand a higher expected return to compensate for that extra risk.
Related terms: CAPM (Capital Asset Pricing Model), Beta, WACC (Weighted Average Cost of Capital)