Cost of Equity Calculator (CAPM)
This calculator computes the cost of equity using the Capital Asset Pricing Model (CAPM), which estimates the return investors require for holding a company's stock based on its risk relative to the market.
Enter either (1) Risk-Free Rate, Beta, and Market Return OR (2) Risk-Free Rate, Beta, and Equity Risk Premium.
Enter CAPM Parameters
Understanding Cost of Equity and CAPM
What is Cost of Equity?
The cost of equity represents the return a company must offer investors to compensate for the risk of investing in its stock. It's a key component in calculating a company's weighted average cost of capital (WACC).
Capital Asset Pricing Model (CAPM) Formula
The primary cost of equity formula using CAPM is:
Ke = Rf + β × (Rm - Rf)
Where:
- Ke = Cost of Equity
- Rf = Risk-Free Rate (e.g., 10-year government bond yield)
- β = Beta (stock's volatility relative to the market)
- Rm = Expected Market Return
- (Rm - Rf) = Equity Risk Premium (ERP)
Key Concepts
- Risk-Free Rate (Rf): The return on a theoretically risk-free investment (e.g., U.S. Treasury bonds).
- Beta (β): Measures a stock's sensitivity to market movements. β > 1 means more volatile than the market.
- Market Return (Rm): The expected return of a broad market index (e.g., S&P 500).
- Equity Risk Premium (ERP): The excess return investors demand for holding stocks over risk-free assets.
Cost of Equity Calculation Examples
Click on an example to see step-by-step calculations:
Example 1: Basic CAPM Calculation
Scenario: Calculate cost of equity for a company with average market risk.
1. Known Values: Rf = 3%, β = 1.0, Rm = 8%.
2. Formula: Ke = Rf + β × (Rm - Rf)
3. Calculation: Ke = 3% + 1.0 × (8% - 3%) = 3% + 5% = 8%
4. Result: Cost of Equity = 8%
Interpretation: Investors expect an 8% return for holding this stock.
Example 2: High-Beta Stock
Scenario: A tech startup with higher volatility than the market.
1. Known Values: Rf = 2.5%, β = 1.8, Rm = 9%.
2. Formula: Ke = Rf + β × (Rm - Rf)
3. Calculation: Ke = 2.5% + 1.8 × (9% - 2.5%) = 2.5% + 11.7% = 14.2%
4. Result: Cost of Equity = 14.2%
Interpretation: The higher beta leads to a higher required return.
Example 3: Low-Beta Utility Company
Scenario: A stable utility company with low market risk.
1. Known Values: Rf = 4%, β = 0.6, Rm = 7%.
2. Formula: Ke = Rf + β × (Rm - Rf)
3. Calculation: Ke = 4% + 0.6 × (7% - 4%) = 4% + 1.8% = 5.8%
4. Result: Cost of Equity = 5.8%
Interpretation: Lower beta results in a lower cost of equity.
Example 4: Using Equity Risk Premium (ERP)
Scenario: Calculate Ke when ERP is known instead of Rm.
1. Known Values: Rf = 3.2%, β = 1.3, ERP = 5.5%.
2. Formula: Ke = Rf + β × ERP
3. Calculation: Ke = 3.2% + 1.3 × 5.5% = 3.2% + 7.15% = 10.35%
4. Result: Cost of Equity = 10.35%
Note: Equivalent to using Rm = Rf + ERP = 8.7%.
Example 5: Negative Beta (Rare)
Scenario: A gold mining stock with β = -0.5 (moves inversely to market).
1. Known Values: Rf = 2%, β = -0.5, Rm = 6%.
2. Formula: Ke = Rf + β × (Rm - Rf)
3. Calculation: Ke = 2% + (-0.5) × (6% - 2%) = 2% - 2% = 0%
4. Result: Cost of Equity = 0%
Interpretation: Negative beta can lead to Ke < Rf (theoretical).
Example 6: International Market (Higher ERP)
Scenario: Calculating Ke for a company in an emerging market.
1. Known Values: Rf = 5%, β = 1.2, ERP = 8% (higher for emerging markets).
2. Formula: Ke = Rf + β × ERP
3. Calculation: Ke = 5% + 1.2 × 8% = 5% + 9.6% = 14.6%
4. Result: Cost of Equity = 14.6%
Note: Emerging markets often have higher ERPs.
Example 7: Zero-Beta Company
Scenario: A company with β = 0 (returns uncorrelated with market).
1. Known Values: Rf = 3.5%, β = 0, Rm = 7%.
2. Formula: Ke = Rf + β × (Rm - Rf)
3. Calculation: Ke = 3.5% + 0 × (7% - 3.5%) = 3.5% + 0% = 3.5%
4. Result: Cost of Equity = 3.5% (equal to Rf)
Interpretation: No market risk premium is required.
Example 8: Comparing Two Companies
Scenario: Compare Ke for a tech company (β=1.4) vs. a consumer staples firm (β=0.7).
Common Values: Rf = 2.8%, Rm = 7.5%.
Tech Company: Ke = 2.8% + 1.4 × (7.5% - 2.8%) = 2.8% + 6.58% = 9.38%
Staples Company: Ke = 2.8% + 0.7 × (7.5% - 2.8%) = 2.8% + 3.29% = 6.09%
Conclusion: Higher-beta tech stock has a significantly higher cost of equity.
Example 9: Changing Risk-Free Rate
Scenario: How does Ke change when interest rates rise?
Original Values: Rf = 2%, β = 1.1, Rm = 8% → Ke = 8.6%
New Rf = 4%: Ke = 4% + 1.1 × (8% - 4%) = 4% + 4.4% = 8.4%
Observation: Ke increased but by less than Rf due to lower ERP (Rm - Rf).
Example 10: Sector-Specific Beta
Scenario: Using an industry-average beta for a retail company.
1. Known Values: Rf = 3%, β (retail sector) = 1.05, Rm = 9%.
2. Formula: Ke = Rf + β × (Rm - Rf)
3. Calculation: Ke = 3% + 1.05 × (9% - 3%) = 3% + 6.3% = 9.3%
4. Result: Cost of Equity = 9.3%
Note: Industry betas are often used when company-specific beta is unavailable.
Frequently Asked Questions about Cost of Equity
1. What is the cost of equity formula in CAPM?
The CAPM formula is: Ke = Rf + β × (Rm - Rf), where Ke is the cost of equity, Rf is the risk-free rate, β is beta, and Rm is the expected market return.
2. How do I estimate the risk-free rate (Rf)?
Use the yield on long-term government bonds (e.g., 10-year U.S. Treasury) as a proxy for Rf. For U.S. companies, this is typically 2-4% historically.
3. Where can I find a stock's beta (β)?
Beta is available from financial databases like Bloomberg, Yahoo Finance, or your brokerage platform. It measures a stock's volatility relative to the market (β = 1 means market-average risk).
4. What is a typical market return (Rm)?
The historical average annual return of the S&P 500 is ~7-10% (nominal). For long-term estimates, many use 8% as Rm.
5. Can cost of equity be lower than the risk-free rate?
Only if beta is negative (very rare). Most stocks have β > 0, so Ke > Rf. Example: If β = -0.2, Ke = Rf - 0.2 × ERP.
6. Why use CAPM instead of other models?
CAPM is simple and widely accepted, but alternatives like the Dividend Discount Model (DDM) or Fama-French models may be used for specific cases.
7. How does beta (β) affect cost of equity?
Higher beta = higher Ke. Example: If β = 1.5, the stock is 50% more volatile than the market, so investors demand higher returns.
8. What is a reasonable equity risk premium (ERP)?
ERP = Rm - Rf. Historically, ERP ranges from 4-6% for developed markets. Emerging markets may have ERP > 8%.
9. How do interest rates impact cost of equity?
When Rf rises, Ke typically increases (but ERP may shrink if Rm doesn't rise proportionally).
10. Can CAPM be used for private companies?
Yes, but you must estimate beta using comparable public companies or industry averages.
