In order to calculate discount rate, one of the most important components of the calculation is the cost of equity. Cost of equity can be defined as the rate of return required by a company’s common stockholders. If shareholders do not receive the return that they expect out of their investment, they may be inclined to sell their shares. Thus, a company will have to make sure it returns what its investors desire, through share appreciation and dividends.
While a number of different cost of equity models are currently employed by valuation professionals, they usually have three components in common: risk-free rate, beta and equity risk premium.
This number typically corresponds to what an investor expects to receive from investing in a security with zero risk. While even the safest investment vehicles, such as U.S. Government bonds, cannot be truly risk-free, they are the closest thing. The portion of a U.S. Government bond that is virtually riskless is its yield. Thus, most use the yield on a long-term U.S. Government bond as their risk-free rate.
Beta or Industry Risk Premium
This figure attempts to quantify a company’s risk relative to the overall 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 equity calculation. From a 10,000 foot view, it can be defined as the expected return on stocks over bonds. Since stock investors are taking on more risk versus those investing 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.
Cost of Equity Formulas
Now that we gave you the ingredients for your cost of equity calculation, you probably need a formula to plug those into. There are two commonly-accepted 메이저놀이터 methods for calculating the cost of equity: Capital Asset Pricing Model (CAPM) and the Buildup Method.
A gentleman by the name of William Sharpe, a financial economist and Nobel laureate in economics, invented the CAPM where the cost of equity equals: Risk-free rate + (beta x equity risk premium)
Ibbotson Associates is generally credited with developing the buildup method. In this model, the cost of equity equals: Risk-free rate + equity risk premium + size premium + industry risk premium
While we haven’t covered the size premium, and briefly touched on the industry risk premium, we will leave those to the experts and suggest you look into purchasing one of Ibbotson’s publications for the data and for more information.
Cost of Debt
As we saw above, the cost of equity can be a tricky little calculation. Luckily, the cost of debt is a little more straightforward. This number typically corresponds to the interest rate a company is paying on all of its debt, such as loans and bonds. Companies of higher risk will usually have a higher cost of debt.
When you break up how a company is financing it business operations-either by issuing stocks or by selling bonds-this can be referred to as its capital structure. This is also known as a company’s debt-to-equity ratio. Is a company more heavily financed by debt or by equity? These will obviously sum to 100%.