Calculate the cost of equity using the Capital Asset Pricing Model (CAPM).
Cost of Equity (Ke)
— %
Understanding the Cost of Equity
The Cost of Equity (Ke) represents the return a company requires to compensate its equity investors for the risk of owning stock. It's a crucial component in financial analysis, valuation, and investment decision-making. A higher cost of equity implies higher risk for investors, and thus, a company will need to generate higher returns on its investments to satisfy them.
The Capital Asset Pricing Model (CAPM)
The most widely used method for calculating the Cost of Equity is the Capital Asset Pricing Model (CAPM). The CAPM formula is:
Ke = Rf + β * (Rm - Rf)
Where:
Ke: Cost of Equity
Rf: Risk-Free Rate (the theoretical return of an investment with zero risk, typically represented by the yield on long-term government bonds like U.S. Treasury bonds).
β: Beta (a measure of a stock's volatility in relation to the overall market. A beta of 1 means the stock moves with the market; a beta greater than 1 means it's more volatile; a beta less than 1 means it's less volatile).
(Rm - Rf): Market Risk Premium (the excess return that investing in the stock market provides over the risk-free rate. `Rm` is the expected return of the market).
How to Use the Calculator
Our calculator simplifies the CAPM calculation for you. Simply input the following values:
Risk-Free Rate (%): Enter the current yield of a long-term government bond (e.g., 3.5% for 3.5).
Beta (β): Find your company's beta from a financial data provider. If the stock is more volatile than the market, beta will be > 1; if less volatile, beta will be < 1. If you don't have a specific beta, you might use an industry average or a calculated beta.
Market Risk Premium (%): This is the expected return of the market minus the risk-free rate. For example, if the market is expected to return 8.5% and the risk-free rate is 3.5%, the premium is 5.0% (5.0).
Click "Calculate Cost of Equity," and the tool will provide the required return for equity investors.
Why is Cost of Equity Important?
The cost of equity is fundamental for several financial decisions:
Discount Rate for Valuations: It's used in discounted cash flow (DCF) analysis to determine the present value of a company's future cash flows.
Investment Appraisal: Companies use their cost of equity (often as part of the Weighted Average Cost of Capital – WACC) to evaluate whether new projects or investments are likely to generate sufficient returns.
Performance Measurement: It sets a benchmark for assessing the performance of equity investments.
Capital Budgeting: Helps in deciding how to allocate capital effectively.
A well-calculated cost of equity provides a realistic hurdle rate that the company's investments must clear to create shareholder value.
function calculateCostOfEquity() {
var riskFreeRate = parseFloat(document.getElementById("riskFreeRate").value);
var beta = parseFloat(document.getElementById("beta").value);
var marketRiskPremium = parseFloat(document.getElementById("marketRiskPremium").value);
var resultValueElement = document.getElementById("result-value");
// Clear previous result
resultValueElement.innerHTML = "– %";
// Input validation
if (isNaN(riskFreeRate) || isNaN(beta) || isNaN(marketRiskPremium)) {
alert("Please enter valid numbers for all fields.");
return;
}
// CAPM Calculation
// The formula is Ke = Rf + Beta * (Rm – Rf)
// The marketRiskPremium is already (Rm – Rf)
var costOfEquity = riskFreeRate + beta * marketRiskPremium;
// Format the result to two decimal places
resultValueElement.innerHTML = costOfEquity.toFixed(2) + " %";
}