What is the cost of equity?
In calculating the discount rate, one of the most important components of the calculation is the cost of equity. The cost of equity can be defined as the rate of return required by the common shareholders of a company. If shareholders do not receive the return they expect from their investment, they may be inclined to sell their shares. Therefore, a company will have to ensure that it returns what its investors want, through stock appreciation and dividends.
While valuation professionals currently employ several different equity cost models, they generally have three components in common: risk-free rate, beta, and equity risk premium.
Risk-free rate
This number typically corresponds to what an investor expects to receive by investing in a zero risk security. While even the safest investment vehicles, like US government bonds, can’t really be risk-free, they are the closest thing. The part of a US government bond that presents virtually no risk is its yield. Therefore, most use the yield on a long-term US government bond as their risk-free rate.
Industry risk premium or beta
This figure attempts to quantify a company’s risk relative to the broader market, typically represented by the S&P 500. A company with a beta greater than one is riskier than the market, while one with a beta less than one contains less. risk.
Similarly, a company that participates in an industry that has a positive risk premium is riskier than the market, while an industry with a negative risk premium contains less risk.
Equity risk premium
This may be the most debated underlying figure used in a cost of capital calculation. From a 10,000 foot view, it can be defined as the expected return of stocks on bonds. Since investors in stocks are taking more risks than those who invest in bonds or risk-free assets, they want to be compensated accordingly. The equity risk premium has been calculated using a variety of different approaches.
Equity cost formulas
Now that we’ve provided you with the ingredients for your cost of equity calculation, you probably need a formula to incorporate them. There are two commonly accepted methods for calculating the cost of capital: the capital asset pricing model (CAPM) and the accumulation method.
CAPM
A gentleman named William Sharpe, a financial economist and Nobel laureate in economics, invented the CAPM where the cost of shares equals: Risk-free rate + (beta x risk premium of shares)
Accumulation method
Ibbotson Associates is generally credited with developing the accumulation method. In this model, the cost of stocks equals: risk-free rate + equity risk premium + size premium + industry risk premium
While we have not covered the size premium and briefly addressed the industry risk premium, we will leave that to the experts and suggest that you consider purchasing one of Ibbotson’s posts to get the data and more information.
Cost of debt
As we saw earlier, the cost of equity can be a small and complicated calculation. Fortunately, the cost of debt is a bit more straightforward. This number generally corresponds to the interest rate a business pays on all of its debt, such as loans and bonds. Higher risk companies tend to have a higher cost of borrowing.
Capital structure
When the way a company finances its business operations is divided, whether by issuing shares or selling bonds, this can be referred to as its capital structure. This is also known as a company’s debt-to-equity ratio. Is one more company financed with debt or equity? Obviously these will add up to 100%.
The grand finale
I’m sure your head is spinning at this point, so let me conclude with an example. Hopefully this will help solidify the discount rate calculation. We will calculate the discount rate for Kruger Industrial Smoothing (fictitious company).
Cost of capital: 12%
Cost of Debt: 6%
Share capital: 60%
Debt capital 40%
Weighted Average Cost of Capital (WACC) brings together your cost of equity and cost of debt calculations, while using the company’s capital structure. The Kruger Industrial Smoothing WACC is calculated as follows:
(60% x 12%) + (40% x 6%) = 9.6%
And there you have it: 9.6% is the discount rate that will be used in your discounted cash flow analysis.