The cost of equity is the return demanded for an individual equity. It’s the return needed for investors to compensate for equity risk, and it’s the cost of equity funding for the company.
The cost of equity is relatively easy to conceptualize and calculate. It’s what’s you can get for free plus the equity risk premium scaled up or down based on its relative risk compared to the market.
Calculating Cost of Equity
The cost of equity calculation depends on the company’s relationship with its market and risk. There are four possibilities and three approaches. Also, if you do not have access to the market data needed for these calculations, they’re listed in the resources section below
- Company in a mature market
- Company in a risky market
- Company in a mature market with country risk
- Company in a risky market without country risk
Mature Market Cost of Equity
If the company is in a mature market, there is no need to factor in additional country risk.
coe = rf + mp * beta
Where:
- coe: Cost of Equity
- rf: Risk-free Rate
- mp: Mature Market Equity Risk Premium
- beta: Bottom-up Beta
Risky Market Cost of Equity
For companies located and doing business in a risky country, add the market’s bond default spread and scale it up based on how much more volatile the equity market is compared to the bond market.
coe = rf + mp _ beta + (ds _ cp)
Where:
- coe: Cost of Equity
- rf: Risk-free Rate
- mp: Mature Market Equity Risk Premium
- beta: Bottom-up Beta
- ds: Bond Default Spread
- cp: Volatility Derived Country Risk Preimum
The Lambda Approach
If a company’s risk is substantially different from its country risk, use the lambda \lambda approach. The lambda approach can find significantly undervalued businesses in times where countries risk is high.
For example, imagine two companies in the same line of business located in a risky country. If the first company generates its revenues from the United States and the other generates its revenue from its home country, the former is less risky.
Lambda isn’t complicated. Just like beta, it’s a relative risk measure used to scale up or down the country risk. It’s calculated as the ratio of the selected risk measure. The following lambda uses revenue:
lambda = x/y
Where:
- lambda: Relative Risk Measure
- x: Percent of Revenues for Firm
- y: Percent of Revenue for Average Firm
coe = rf + mp _ beta + lambda _ ds * cp
Where:
- coe: Cost of Equity
- rf: Risk-Free Rate
- mp: Mature Market Equity Risk Premium
- beta: Bottom-up Beta
- lambda: Relative Risk Measure
- ds: Bond Default Spread
- cp: Country Volatility Derived Risk Premium
