Cost of Equity

Shareholders do not receive a fixed interest rate. They are paid through dividends and increases in the share price, neither of which is guaranteed. Because they take more risk than lenders, they expect a higher return. The cost of equity is that expected return, seen from the company's side as the cost of using shareholders' money.

The cost of equity cannot be observed directly, so it is estimated. The most common method is the Capital Asset Pricing Model (CAPM), which adds a risk premium to a risk-free interest rate, adjusted for how sensitive the share is to market movements. Another approach, for dividend-paying companies, uses the dividend yield plus the expected growth rate of dividends.

For example, a company might estimate its cost of equity at 10%. This means that, on average, investments funded by shareholders need to earn at least 10% to satisfy them.

The cost of equity is usually higher than the cost of debt, both because equity is riskier and because dividends are not tax-deductible. It is a key input into the weighted average cost of capital and into company valuations.