The Cost of Equity

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

  1. Company in mature market
  2. Company in risky market
  3. Company in mature market with country risk
  4. Company in 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.

\[CostOfEquity = RiskFreeRate + MatureMarketERP * BottomUpBeta\]

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 upon how much more volatile the equity market is compared to the bond market.

\[CostOfEquity = RiskFreeRate + MatureMarketPremium * BottomUpBeta +\ldots\\ (BondDefaultSpread * VolitilityDerivedRiskyCountryPremium)\]

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:

\[\lambda = \frac{PercentRevenuesFirm}{PercentRevenueAverageFirm}\] \[CostOfEquity = RiskFreeRate + MatureMarketRiskPremium * BottomUpBeta +\ldots\\ Lambda * BondDefaultSpread * VolitilityDerivedRiskyCountryPremium\]

Additional Resources

leo

Leo Smigel

Based in Pittsburgh, Analyzing Alpha is a blog by Leo Smigel exploring what works in the markets.