Cost of Equity
The return required by equity investors to compensate for the risk of owning a company's stock.
What is Cost of Equity?
The cost of equity is the minimum rate of return that equity investors expect to receive for the risk of investing in a company's shares. Unlike the cost of debt, equity has no contractual payment schedule — equity holders are residual claimants who bear more risk than debt holders, so they require a higher expected return. The most widely used model to estimate cost of equity is the Capital Asset Pricing Model (CAPM): Re = Rf + β × (Rm − Rf), where Rf is the risk-free rate, β (beta) measures a stock's volatility relative to the market, and (Rm − Rf) is the equity risk premium. Cost of equity is a key input to WACC and DCF valuation models.
Example
If the risk-free rate (10-year Treasury yield) is 4.5%, the equity risk premium is 5%, and a company's beta is 1.2, the CAPM cost of equity is: 4.5% + 1.2 × 5% = 10.5%. This means investors require at least a 10.5% annual return to justify holding that stock over risk-free alternatives.