The traditional curriculum starts from the premise that the marginal investor (who impacts pricing) is diversified and therefore only cares about non-diversifiable risk, rather than idiosyncratic risk specific to an individual stock. From there students learn the Capital Asset Pricing Model (“CAPM”) including historic and implied equity risk premiums as well as the all-important beta. Then it is criticized as not explaining much of anything and other models are explored.
Finally, like the cavalry in an old western movie, CAPM makes a reappearance and saves the day. It is good enough and easy to use! At the end of all of this, students can be forgiven for shaking their heads in wonder and confusion questioning what any of this has to do with calculating the cost to a company of its shares of stock, whether those shares are outstanding or soon to be issued publicly or privately.
Having thought about this topic for far too long—reviewing numerous textbooks, published articles and lecture notes—and having endeavored to teach this to bright and motivated students, I am convinced that a few more steps in the pedagogical process would go a very long way to eliminating much of the confusion and would leave students with a much more intuitive understanding. The models and financial calculations could then be used with some degree of confidence and with considerable caution. Letʼs start at the beginning.
The Cost of Capital—Debt Companies both large and small finance their operations and required capital investments in many ways. Banks (and more recently non-bank “private debt” providers) offer working capital lines secured by receivables and inventory. They extend term loans supported by the borrowerʼs hard assets and cash flows.
Companies also finance themselves through the capital markets by issuing debt securities, convertible securities and stock—both preferred and common. Putting aside for the moment convertible securities and common stock, these financing tools are fairly simple to understand. A company borrows money from a bank, insurance company or other private lender or issues debt securities which are sold publicly (and often actively traded).
The United States has by far the largest and most developed public debt market in the world. Elsewhere, bank borrowing is more prevalent. In any event, the borrower agrees to repay the borrowed funds as well as interest.
The rate of interest is stated,e.g.5.25%, 8.50%, 12.30%[1], and reflects the credit quality of the borrower, the structure of the debt including its position in the companyʼs capital structure (e.g.secured, senior, subordinated, junior subordinated etc.), as well as prevailing interest rates usually described as the “risk-free rate.” For borrowers of US dollars this means the rate paid by the US Government, assumed to be free of any credit risk. Companies can expect to pay a spread above the risk-free rate. It is not difficult to determine the cost of debt.
Generally, it is the stated interest rate though for bonds it needs to be adjusted for any discount or premium at issuance.[2] To be precise, fees and other expenses would need to be factored in, though this is generally ignored for cost of capital calculations. There are numerous sources of information on the costs of public debt securities (a Bloomberg terminal being only one example); locating similar information on bank financing and privately placed debt can be more challenging. Having said all of that, the cost of debt is observable and determinable, with a high degree of precision— evidenced by the fact that the cost is generally quoted in basis points, representing 1/100th of 1 percent.
None of this applies to equity! The Cost of Capital—Equity We all know what equity is—the common stock issued by a corporation representing ownership of the entity.[3] It has no contractual right to receive any payment. Rather, it has a residual claim on the assets and earnings of a company after all its contractual commitments have been discharged.
So far, itʼs all straightforward and understandable. Now letʼs ask ourselves “What is the cost of that equityto the company?” At the risk of appearing ancient I will mention that my first exposure to that question was as a young and inexperienced banker in London back in 1986.[4] I heard from more than one Finance Director of a major European corporation that issuing equity was less expensive than the debt we were pitching since the company paid a very low dividend. Having attended law school rather than business school I was lacking the intellectual framework and tools to argue the point, though my instincts told me that it couldnʼt possibly be true.
As it turned out, I was correct though I wonder if the traditional finance curriculum would have prepared me to counter the point in athoughtfulandinsightfulway. It is worth repeating. When a company issues equity, it is selling an ownership stake in the enterprise.
This is totally unlike debt which represents an obligation to repay principal and interest and nothing more. The first step in understanding the cost of equity is the insight that “cost” as applied to equity is an unfortunate and misleading term. There is no easily observable cost of equity like there is with debt.[5] Certainly it is more than just the cost of quarterly dividends, or the equivalent spent on stock buy backs, which have recently become the predominant form of returning cash to shareholders.
Many companies, particularly “growth companies” do neither. No one would seriously argue that their equity is costless. A share of future earnings and free cash flow certainly has real value—potentially enormous—but how do you determine the cost of that share to the issuing company, particularly when future earnings and cash flow are unknown today?
At this point teachers and practitioners of corporate finance, to make progress on the question at hand—the cost of equity capital—change focus from the company to its investors. We can determine a companyʼs cost of equity by looking at the returns achieved by its investors. There is a certain logic to this but an equal amount of desperation, a search for an analytical framework that is quantitative and reducible to linear equations.
Letʼs proceed slowly, making sure we understand all the assumptions we are making along the way. First, to what extent do the returns of investors represent costs to the company? Again, the comparison to debt is instructive.
If a company borrows money and pays interest of 6%, for example, and repays the principal at maturity, it is obvious that investors have earned 6% on the funds loaned and the company has had a cost of 6% on the same amount of borrowed money. But letʼs say an investor invests $250,000 in a companyʼs stock—one that pays no dividends—holds it for three years and then sells it in the market for $350,000. The investor has earned a compounded return of 11.87%.
Is it accurate, fair or even remotely logical to conclude that the company has incurred a cost of 11.87%? What if the stock is sold for $300,000? Or at a loss for $230,000?
Is the cost determinedex post factobased upon the results of the investment? What do we do with the fact that numerous investors will each achieve different investment results? The only logical approach is to look for a different analytical framework.
Why does a company want to calculate its cost of equity? When it issues shares—privately, for example in a Series A, B or C round; in an initial public offering; or in a subsequent follow-on offering—it certainly wants to know their cost,i.e.what it is giving up in exchange for payment for its stock. At least conceptually, this is achieved by developing projections (an educated guess) for the free cash flow that the company will generate over an explicit forecast period and beyond (captured by use of the perpetuity formula).
We then discount the free cash flow attributable to the equity by some discount rate to calculate the value of the equity today. That discount rate is called the “cost of equity.”[6] We are determining the value today (the present value or “PV”) of the expected cash flows generated by the company in the future. No one would sensibly pay dollar for dollar.
They need to be discounted for time value and risk. That discounting of its future cash flows is the cost that the company bears related to its shares of stock. Before looking at the cost of equity in any detail, letʼs identify some fundamental points.
Stocks are risky—certainly more so than government debt that is considered to be risk free or corporate debt that is senior in the capital structure (perhaps secured) and represents an unconditional obligation to pay principal and interest. Investors will choose to hold stock only if they have the expectation (i.e.hope) of earning a higher return, one sufficient to compensate them for the additional risk. So, the discount rate applied by investors to determine the value of a companyʼs future cash flows is also the return that investors expect to achieve from owning the stock.
It is forward looking, derived from a future that is ultimately unknown and therefore represents nothing more than yet another educated guess. What is so wonderful—if I can use that word in this context—is that there is a symmetry here. The same cost of equity calculation serves two different but extremely related concepts.
It is two sides of the same coin. It represents thereturninvestors are demanding for holding a companyʼs stock considering projected future cash flows and thediscount rateapplied to those future cash flows reflecting the risks inherent in that forecast. And now we can see another extremely important way in which the cost of equity represents a true “cost to the company.” Unlike debt it is not a fixed obligation of the company requiring it to expend cash.
If the company is not paying dividends or buying back its stock in the market, the cost of equity becomes rather conceptual and abstract. It is the rate of return that investors are seeking, expecting, demanding (depending on oneʼs perspective) as compensation for investing in the companyʼs stock. Therefore, it represents thehurdle ratewhich the company needs to achieve as a ROE.
Failure to do so will negatively impact the companyʼs share price and may well attract the interest and involvement of activist shareholders with all the resulting consequences for management and the board. Quantifying the Cost of Equity As I noted at the outset, teaching students about the cost of equity usually begins with a presentation of the Capital Asset Pricing Model (“CAPM”).[7] Developed by William F. Sharpe, a Nobel-winning economist known for many contributions including the famous Sharpe Ratio, it built upon the earlier work of Harry Markowitz who is considered the father of modern portfolio theory (he shared the Nobel with Sharpe).
It is deceptively simple looking with only three inputs. Those are the risk-free rate (we have seen earlier); an equity risk premium which is the expected return premium investors require to hold a diversified equity portfolio; and a stockʼs beta, intended to capture the covariance between the market and the stock. In case you missed it, we are ignoring anything and everything that has to do with the company itself— its products, markets, technology, brand, invested capital, management and a whole lot more.
The advantage of this approach is that it makes the computation of a companyʼs cost of equity relatively easy and very mechanical. The simplicity of the model, however, obscures the numerous assumptions underlying CAPM: (1) investment risk is best measured by a mean/variance framework; (2) returns are normally distributed; (3) the only way to earn higher returns is to take additional risk; (4) large investors with diversified portfolios establish the price of stocks; (5) diversification can eliminate the risk specific to any individual stock (“idiosyncratic risk”) and therefore the market rewards only the taking of undiversifiable market-wide risk (“systemic risk”)[8]; (6) systemic risk is best captured by a stockʼs beta (“b”) determined by regressing its returns against that of the market as a whole. Each of these assumptions has been the subject of numerous academic articles—if not books—and comes with enough baggage for an extended trip around the world.
Nevertheless, CAPM continues to be the most widely used model for calculating the cost of equity, notwithstanding its “many theoretical and empirical shortcomings.”[9] That is a polite way of saying that lots of intelligent people think that it is garbage. As Yogi Bera is reported to have said “In theory, theory and practice are the same. In practice they are not.”[10] So why are CAPM and its progeny still widely taught and used?
I believe this is due in large part to the commendable desire to make corporate finance and the investment process scientific and quantifiable—its problems tractable. But like economists, finance and investment professionals seem to suffer from a fair bit of “Master Model Mentality” and “physics envy”[11], the desire to describe extraordinarily complex systems of human interaction with Newtonian formulas. Mean/variance is easy to compute; it is easier to do away with company-specific or idiosyncratic risk; regression analysis yields definitive calculations that come with t-statistics, p-values, R- squares and standard errors.
It is all very precise and reassuring. Yet the reality is that it is only a starting point, an approximation, a single point of view. In the end CAPM is used because it is “good enough.”[12] While CAPM remains the most commonly taught and applied method for estimating the cost of equity, it is far from the only one.
Alternative models such as the Fama-French Three-Factor Model and the Arbitrage Pricing Theory (APT) offer more nuanced approaches to explaining returns by incorporating additional risk factors. However, these models also introduce more complexity and data requirements, making them less practical for everyday use despite their theoretical appeal. In practical settings, firms often use a combination of empirical data and judgment to estimate their cost of equity.
This might include benchmarking against peer companies, using industry averages, or adjusting for qualitative factors like management quality or market volatility. Where Does that Leave Us? Equity is not like debt.
It does not have a readily observable and quantifiable cost to the issuing company. When academics and corporate finance practitioners refer to the cost of equity, they are referring to the expected return that investors require to hold a companyʼs stock, which (thankfully but unremarkably) is also the discount rate used to present value future cash flows when determining the intrinsic value of a stock. When a borrower fails to make the necessary payment of interest or principal on debt the results are immediate and unpleasant—default, acceleration and potentially bankruptcy.
Failure to provide investors with their expected equity return has less immediate and painful consequences. But as noted earlier, the stock will languish or decline, and management and the board may find themselves under increasing amounts of duress. Perhaps it is best and correct to say that the cost of debt and the cost of equity sharesomesimilar attributes after all.
APPENDIX The Capital Asset Pricing Model [1] Sometimes you will hear this referred to as the “coupon rate” which is a reference to the fact that pre-1983 bonds were issued with physical coupons attached. An investor would clip the coupon and take it to the “paying agent”, receive payment and (not surprisingly) often fail to report the payment to the US tax authorities. Bearer bonds with coupons were essentially prohibited by the Tax Equity and Fiscal Responsibility Act of 1982 (commonly referred to as “TEFRA”).
Nice name but in view of the past 40 years—you must be joking. [2] To the extent that the risk-free rate or the appropriate spread has moved since the time of borrowing, the debt will “trade” in the secondary market at a new price reflecting those changes. [3] Preferred stock is a hybrid security with attributes of both debt and equity.
Like debt it pays a fixed amount and does not participate in a companyʼs upside. It ranks junior to the most subordinated debt issued by a company and can only legally be paid out of a companyʼs paid-in capital or accumulated earnings. For our purposes we will treat it as “debt” unless it is convertible into common stock, in which case it becomes a bit more complicated—all of which we will ignore for present purposes.
[4] I have probably already appeared near prehistoric with my reference to TEFRA. [5] Unfortunately, the formula for the Weighted Average Cost of Capital (“WACC”) implies otherwise. Calculate the after-tax cost of debt; calculate the cost of equity; determine their relative weights in the companyʼs capital structure; and BINGO youʼre home free.
This implies a level of simplicity that is very misleading. [6] We will use the WACC (which incorporates the cost of equity, see fn. 5, above) if we are dealing with free cash flow to the firm.
[7] In case you forgot. See Appendix for the formula. [8] I have now made this point three times.
I apologize for that, but it is so very fundamental to the concept of the cost of equity that it merits repetition. [9] I would like to give credit to the author of this phrase but cannot remember where I read it. [10] [10] If you donʼt know who Yogi Berra was, look him up.
The quote is also often attributed to Albert Einstein (along with a lot of other things he never said such as “Compound interest is the eighth wonder of the world”—which it probably is) and Benjamin Brewster (who cares). [11] Paul Swartz and Philipp Carlsson-Szlezak, Shocks, Crises, and False Alarms-How to Assess True Macroeconomic Risk (Harvard Business Press, 2024) p.20. [12] A similar mentality underlies the use of the Black-Scholes option pricing model to price almost all equity options.
Its reliance on the normal distribution of stock returns (lognormal distribution of prices) is recognized as a major shortcoming, but alternative distributions would vastly complicate the mathematics and the tools required to calculate option values. 12·2 comments