Cost of Equity: Formula, CAPM, and Use Cases

Ever wish you could know whether a stock will actually pay off?

That moment before you click “Buy”, it comes down to weighing risk against reward. And one of the key metrics investors use to make that call is cost of equity.

While it can’t predict the future, cost of equity helps estimate whether an investment’s return justifies the risk, and plays a major role in company valuation, capital budgeting, and financing strategies. It’s also a core feature in many modern investment portfolio management tools, which use this metric to guide smarter asset allocation and ROI forecasting.

Below, we break down everything you need to know: formulas (CAPM & dividend model), examples, use cases, benchmarks, and limitations. Let’s dive in.

Cost of equity is the return that an investor requires for investing in a company, or the required rate of return that a company must receive on an investment or project. It answers the question of whether investing in equity is worth the risk. It is also used, along with cost of debt, as part of the calculation of a company’s weighted average cost of capital, or WACC.

There are two ways to calculate cost of equity: using the dividend capitalization model or the capital asset pricing model (CAPM). Neither method is completely accurate because the return on investment is a calculation based on predictions about the stock market, but they can both help you make educated investments.

Take note of the formulas below:

Don’t be afraid if the symbols seem complicated, we’ll break down everything that goes into these calculations in this article.

How do you calculate cost of equity?

The method you choose to calculate cost of equity depends on the type of investment you are analyzing and the level of accuracy you need. Remember, neither method is completely accurate (we can’t predict the future like we can when we calculate cost of debt), but both are still helpful estimates.

The dividend capitalization model requires that the stock you are analyzing earns dividends. If the investment in question does not earn dividends, you must use the CAPM formula, which is based on estimates about the company and stock market. Read on to learn what information goes into each.

Dividend capitalization model (DCM)

You already know that this model is used to determine the cost of equity of dividend stocks, so you can surmise that dividends play a part in using this equation. But what other information do you need?

Using this model, find the cost of equity of a dividend stock by dividing yearly dividends per share by the current price of one share, then adding the dividend growth rate.

Formula:
Re = (D1 / P0) + g

Where:

D1 = Expected annual dividend

P0 = Current stock price

g = Expected dividend growth rate

Note: Assumes consistent dividend growth. Does not account for risk or capital appreciation.

Example: McDonald's:

• Price per share = $205.27
• Annual dividend = $4.64
• Dividend growth = 15%

Re = 4.64 / 205.27 + 0.15 = 17%

Keep in mind that this model does not account for stock appreciation or risk. It also presumes that the dividend payment will go up rather than stay the same or go down.

Capital asset pricing model (CAPM)

While the CAPM for finding cost of equity is a little more complicated, it is a little bit more accurate because it accounts for the risk associated with the particular stock you are analyzing.

Using this model, find the cost of equity (or expected return of investment) by adding the risk-free rate to the beta risk of the investment multiplied by the market risk premium (found by subtracting the risk-free rate from the expected return on investment). 

Formula:
E(Ri) = Rf + β(E(Rm) - Rf)

Where:

Rf = Risk-free rate (e.g., Treasury yield)

β = Beta (stock volatility vs. market)

E(Rm) = Expected market return

Example: McDonald's:

• Beta = 0.72
• Risk-free rate = 2.17%
• Market return = 10%

E(Ri) = 0.0217 + 0.72(0.1 - 0.0217) = 7.8%

Keep in mind that this model does not account for the dividends earned by a particular stock.

Why cost of equity matters

Cost of equity isn’t just a formula, it’s a strategic lever in corporate finance and investment decision-making. Here's why:

• Company Valuation: Used in discounted cash flow (DCF) models to determine present value of future cash flows.
• Capital Budgeting: Helps evaluate whether projects clear a required rate of return (the “hurdle rate”).
• Financing Strategy: Informs whether a firm should raise funds through equity or debt.

Investor impact

For individual and institutional investors, cost of equity provides a risk-adjusted lens for comparing opportunities. A stock yielding 12% might seem attractive, but if its cost of equity is 13%, it's not beating expectations.

Cost of equity vs. cost of debt

For example: A company may pay 5% interest on bonds (cost of debt), but equity investors may demand 9% returns due to volatility and no guarantee of payout.

What is the role of cost of equity in WACC?

WACC (Weighted Average Cost of Capital) represents a company’s average cost of financing, both debt and equity, adjusted for their proportion and risk.

Formula:
WACC = (E/V) * Re + (D/V) * Rd * (1 - Tc)

Where:

E = Market value of equity

D = Market value of debt

V = E + D

Re = Cost of equity

Rd = Cost of debt

Tc = Tax rate

Why it matters: A higher cost of equity increases WACC, which lowers firm valuation in DCF models.

What are the limitations of CAPM?

While CAPM is widely taught and used, it relies on several theoretical assumptions that don’t always hold in the real world.

Takeaway: CAPM is best used as a baseline, not a definitive answer. Pair it with qualitative insight and other financial metrics.

Industry benchmarks for cost of equity

Knowing the average cost of equity by sector helps investors and analysts compare apples to apples.

Tip: Use these ranges as sanity checks for your calculations. Outliers may indicate overvaluation or hidden risk.

Practical applications: How CFOs and investors use it

• Capital structure optimization: CFOs use cost of equity to find the ideal mix of debt and equity.
• Investment screening: Portfolio managers filter out low-return, high-risk stocks.
• Project evaluation: Finance teams set hurdle rates aligned with the company’s cost of capital.
• Valuation modeling: Equity analysts incorporate cost of equity in DCF, APV, and EVA frameworks.
• M&A decisions: Helps assess whether an acquisition adds value after factoring in capital costs.

Real use case: A CFO may reject a proposed project with an 8% IRR if the company’s cost of equity is 9%, even if the project appears profitable.

Frequently asked questions (FAQs) on cost of equity 

Have more questions? Find the answers below. 

Q1. What is cost of equity in simple terms? 

Cost of equity in simple terms is the return a company must give investors for buying and holding its stock. It shows how much profit shareholders expect based on the risk of investing. Companies use it to decide if a project or investment will earn enough to satisfy shareholders.

Q2. How do you calculate cost of equity using CAPM?

Calculate cost of equity using CAPM with this formula: Cost of Equity = Risk-Free Rate + Beta × (Market Return – Risk-Free Rate). The risk-free rate reflects safe investments like government bonds, beta measures stock volatility, and market return is the average return expected from the market.

Q3. What is the difference between cost of equity and cost of debt? 

The main difference between cost of equity and cost of debt is that cost of equity is the return expected by shareholders, while cost of debt is the interest a company pays on its loans. Cost of debt is usually lower and tax-deductible, but cost of equity reflects higher investor risk.

Q4. Why is cost of equity important for businesses? 

Cost of equity is important for businesses because it helps determine the minimum return they must earn to satisfy shareholders. It guides investment decisions, capital budgeting, and project evaluations. A company that earns below its cost of equity risks losing investor confidence and decreasing its stock value.

Q5. What are the limitations of CAPM? 

The main limitations of CAPM are its unrealistic assumptions. It assumes all investors have equal access to information, markets are efficient, and risk is measured only by beta. CAPM ignores taxes, transaction costs, and changes in investor behavior, which can make its predictions unreliable in real-world conditions.

Q6. What industries typically have higher cost of equity? 

Industries with higher cost of equity include technology, biotech, and startups. These sectors face higher uncertainty, rapid change, and greater risk, leading investors to demand higher returns. High-growth industries with volatile earnings often carry a higher cost of equity to compensate shareholders for increased risk.

Q7. How does cost of equity affect WACC and company valuation? 

Cost of equity directly affects WACC by increasing the overall weighted average when it rises. A higher WACC lowers a company’s valuation because future cash flows are discounted more heavily. Since WACC is used in valuation models like DCF, a higher cost of equity reduces estimated company value.

Q8. Is cost of equity always higher than cost of debt?

Yes, cost of equity is almost always higher than cost of debt because equity investors take on more risk. Unlike lenders, shareholders are not guaranteed returns and are last to be paid in case of bankruptcy. To compensate for this risk, they require a higher expected return.

Invest wisely and profit smartly

Cost of equity is one of those finance fundamentals that unlocks smarter decision-making, whether you're building a DCF model, managing capital costs, or trying to decide whether to buy that next stock.

Just remember: formulas like CAPM and the dividend model are powerful tools, but they’re only part of the equation. Combine them with good judgment, quality data, and real-world context for best results.

Investment portfolio management software can help you decide which stocks to invest in and how to manage your portfolio, or if you have a crystal ball that allows you to see into the future of the stock market, use that instead. 

Curious how finance meets tech at scale? Explore how BaaS platforms help businesses modernize their offerings, without starting from square one.

This article was originally published in 2021 and has been refreshed with recent content.