When a business needs to raise money (typically referred to as capital) for projects that are needed for additional growth or to sustain existing growth, it has two financing options. One option is to take on debt through loans. The other option is to issue new shares of stock, which is called equity financing. It’s common for businesses to do both, and the percentages to which they finance through debt and equity make up a company’s capital structure.
However, whatever the source of their funding, there is a cost to the business. In the case of debt, it’s obviously the fact that the debt is required to be repaid. In the case of equity, the cost is not as straightforward as the cost of debt, but for investors and businesses, it is every bit as important.
In this article, we’ll be reviewing the cost of equity from the point of view of both the company and the investor. We'll also review the ways shareholders receive a return on equity, how the cost of equity is shown you how to equity financing is accounted for on a company's balance sheet.
What is cost of equity?
The cost of equity is actually two different, but related concepts, depending on your point of view. For a business, the cost of equity is the expected return they will get from the equity financing they receive. For an investor, the cost of equity is the expected return that they will get in exchange for their investment in a business in the form of buying shares (i.e. providing equity financing).
The cost of equity for a business
A company’s capital structure is made up of their use of debt and equity. A business makes their decision to choose debt financing or equity financing for a variety of reasons. When a company takes on debt, it is usually in the form of loans. When they receive equity financing, they are generally issuing new shares of stock (i.e. pieces of ownership in the company).
If they choose to finance a project through liabilities such as long-term debt or supplier credit, the cost of that debt is fairly easy to calculate based on the interest rates they pay. The cost of equity is less clear and more theoretical. If a company issues a dividend, that can be a known cost, but by itself, dividend payments do not make up the entire cost of equity. A shareholder’s expected rate of return is a cost because if the stock underperforms, an investor can simply sell their shares, which can cause the stock price to drop further. In this way, a large part of the cost of equity to a business is what it costs them to maintain, or increase, their share price to a level that will satisfy investors.
This illustrates an important concept for a business related to their cost of capital and, subsequently, their cost of equity. Where the funding comes from is not as important as what they do with the funds they receive and how quickly their underlying business may see a return on that investment. If a company needs to make a $1,000,000 renovation to one of their manufacturing facilities, the cost of equity will be one consideration they make when deciding how to finance the renovation. If they are anticipating an immediate increase in revenue in the following year, and perhaps an immediate reduction in costs (liabilities), then it may be more cost effective to use debt financing because any interest payments on the debt will be easily serviceable through the increase in revenue and a corresponding dip in liabilities. If however, the payoff for the investment may not be realized for many years in the future, the company may decide equity financing is the better option since they will not have to make repayments aside from projected dividends. Additionally, the market may react favorably to their investment and reward them with positive reviews that can help raise their stock price.
The cost of equity for an investor
Shareholders are repaid for their equity financing in one or both of the following ways. If a company issues dividends, then the shareholder can benefit from the regular, and ideally growing, dividend payments that are made by the company. Dividend payments are generally made either quarterly, semi-annually, or annually. For example, as of November 2018, the dividend yield for Hershey Foods Corporation was 2.7%. Shareholders on record as of the ex-dividend date would receive approximately $0.72 for every share they owned. So if you owned $200 shares of Hershey stock as of the ex-dividend date, you would receive approximately $144. If the yield stayed the same for the entire year (it typically fluctuates for a variety of reasons), and the investor retained the same amount of shares, they could reasonably expect to receive $576 per year in dividend payments.
However, if the investor purchased Hershey’s stock for around $107 per share, their initial investment is worth $21,400 (200 shares x 107 per share). It would take a long time for the investor to recoup their investment through a dividend that is only paying them about a 3% return per year. That brings us to the other way shareholders are repaid for their cost of equity – an increase in the market value of the stock.
The future share price for a company is notoriously tough to predict because there are many factors that can cause a fluctuation in share price, and some of these are out of a company’s control. Still, as much as an investor may want to invest in a company, understanding their expected cost of equity is an important consideration. For this reason, investors and businesses use a couple of formulas to make an intelligent prediction as to the future share price of a company. One is the Dividend Capitalization Model and the other is the Capital Asset Pricing Model (CAPM).
Understanding the Dividend Capitalization Model
The Dividend Capitalization Model (also known as the Dividend Growth Model) is only used if a company pays a dividend. The underlying assumption is that the company has an obligation to pay future dividends and that cost to repay shareholders is their cost of equity. The formula for this is:
Cost of Equity = (Dividend Payout/Current Share Price) + Growth Rate of Dividends
As an example, we can use Hershey's stock from earlier. For the purposes of this example, we'll round up the dividend payout to an even $3 and set their current share price at $100. In this case 3/100 = 3%. If an investor was looking for an 8% return on their equity, then their expectation would be for a combination of a dividend increase or share price increase of 5%.
8% = (3/100) + X; X = 8% - 3%; X = 5%
It is somewhat limited in that it doesn’t factor in such things as a stock’s volatility, but it can be useful to get a quick snapshot of the cost of equity.
Understanding the Capital Asset Pricing Model
The CAPM is considered by many to be the more accurate measurement of cost of equity. CAPM describes the relationship between an asset’s systematic risk and its expected return. It’s primarily used with stocks, but it can be used for other securities as well. The CAPM formula is:
CAPM = risk-free rate + (company beta * risk premium)
Let’s define each of these terms:
Risk-free rate = the current return on a 10-year government bond.
Beta = the price volatility of a stock as a correlation to a standard which is typically the S&P 500. When comparing to the S&P 500, the beta for the S&P 500 is generally listed as 1. So if a stock has a beta of 1, that means it’s highly correlated to the movement of the S&P 500; if it has a beta above 1, it is more volatile than the S&P 500; if it has a beta of less than 1, it is less volatile. Although beta can be a complicated equation, many financial websites will provide an online calculator and many stocks even list their beta as part of their stock summary.
The risk premium is an approximation. If the S&P 500 is being used, an investor can take the average return of the S&P over a period of time and then subtract from that number the risk-free rate. Because government bonds are deemed to be very safe (backed by the full faith and credit of the government) the risk premium is viewed as an estimate for the return an investor might expect when they choose to invest in this stock as opposed to the safety of the 10-year bond.
Why do businesses choose equity financing?
Equity financing can be an attractive option for a couple of reasons. First, a business can generally raise significantly more money through equity than they can through debt. The second reason for a company to choose equity financing over debt is that although a company has an ethical, and some would say moral, obligation to repay their shareholders – and the vast majority of companies do provide a significant return on investment (ROI) for their shareholders – they are not legally obligated to do so. For example, if a company falls on hard financial times they can choose to cancel their dividend payments for a period of time. And, of course, the appreciation of their stock price can be something that’s completely out of their control.
For this reason, while a creditor takes on the risk of a business defaulting on their debt; shareholders assume a risk that they will not receive a sufficient return on their investment. This is why shareholders, particularly the institutional investors or angel investors will perform a cost of equity analysis on a company using one of the models described earlier.
One of the risks of using equity financing is the possibility of diluting the value of current shares which generally drop in value, initially, when new shares are issued. Another concern is that each new investor, assuming they are buying common shares come with voting rights, which can be problematic if a company is not in a good financial position and may be the target of a takeover.
Cost of equity and a company’s balance sheet
Every company’s balance sheet has three components: assets, liabilities, and shareholder’s equity. By definition, every asset has to be balanced by a liability or by shareholder’s equity. This means that every dollar that goes into a business has to be accounted for in some way.
As part of a company’s capital structure, they may target a 60% debt/40% equity capital structure. Based on this capital structure, let’s look at a company that has $1,000,000 in assets with $600,000 coming from revenue (i.e. sales). The additional $400,000 would be accounted for on the balance sheet with the company showing $240,000 in debt (60% of $400,000) and $160,000 in shareholder equity.
While companies will not typically put their cost of equity directly on a balance sheet, understanding their ratio of debt to equity is important for determining their Weighted Average Cost of Capital (WACC).
The final word on cost of equity
When a company needs capital to expand or any of a number of projects, they will frequently look for funds from outside sources rather than taking it out of the business. The two common ways a company will receive this financing is through debt or through equity. While the cost of debt (i.e. loans or supplier credit) is fairly straightforward, the cost of equity is a bit more complex and theoretical.
A company that raises money by offering shares will have a cost of equity. For a company, the cost of equity is a calculation that allows them to weigh the opportunity cost of a project with the anticipated return that shareholders will expect. For an investor, the cost of equity is the amount of return they anticipate for their willingness to invest in one company over another.
If the company pays a dividend, the payout for the dividend, as a percentage, can be used in part to calculate the cost of equity. However, the other component to cost of equity is the rate of return of the stock. This can be tough to measure. One of the best tools for calculating the cost of equity is the Capital Asset Pricing Model (CAPM) which takes into account the relative volatility of a stock in comparison to a benchmark, such as the S&P 500, to get a clearer estimate of the required return.
Companies typically choose equity financing because they can raise a large amount of capital and because they are not legally obligated to pay back the shareholders, although the vast majority of companies make every effort to provide an equitable return on the capital they receive from shareholders.