• Cost of Equity

    There are lots of methods available to the analysts to calculate the cost of equity. Among them, 2 methods are used most widely which are

    • Discounted Cash Flow (DCF) approach
    • Capital Asset Pricing Model (CAPM)

    Discounted Cash Flow (DCF) approach is further divided into two methods depending on the growth of the company. These methods are

    • Constant Dividend Growth Model
    • Two-stage Growth Model

    Constant Dividend Growth Model

    Constant Dividend growth model is used to calculate the cost of equity for companies with the following characteristics

    • They pay dividend regularly and the dividend payout ratio is fixed over the years
    • The growth rate (g) is constant throughout the years.

    The formula to calculate cost of equity is shown below

    Ke = Do*(1+g) /Po + g

    Where,

    Ke = Cost of Equity

    Po = Current Equity Price

    Do = Dividend paid per share at time 0

    g= Constant rate of growth

    Now from this, we can also get the Current price details if other details are known by using the below formula

    Po = Do*(1+g) / Ke- g Provided Ke > g

    Now if we closely look at the formula, we can establish the following relationships

    • Higher Dividend Payout => Higher Cost of Equity
    • Lower current market price => Higher Cost of Equity
    • And Obviously, higher growth => Higher Cost of Equity

    Two-stage Growth Model

    Two-stage Dividend growth model is used to calculate the cost of equity for companies with the following characteristics

    • They pay dividend
    • The growth rate is not constant throughout the years. First the company grows at rapid growth rate and then the growth rate falls back to normal which stay unchanged for ever.

    The formula to calculate cost of equity is shown below.

    First, Share Price after n years of rapid growth is calculated using the Constant dividend growth model after n years till infinity

    Pn = Do*(1+gr)^n*(1+gn) / (Ke –gn)

    Where,

    Pn = Share price at the end rapid growth period (n years)

    Do = Dividend per share paid at time 0

    Ke = Cost of Equity

    gn =Normal growth rate of dividend continuously for ever

    Now, using DCF approach adding the dividend details for rapid growth period we can get the below formula,

    Po = Do*(1+gr) / (1+Ke) + Do*(1+gr)^2 / (1+Ke)^2 + ……. + Do*(1+gr)^n /1+Ke)^n + Pn / (1+Ke)^n

    Where,

    gr = Rapid growth rate of dividend during the first n years

    Solving the equation, we get the value of Ke or Cost of Equity.

    Now if we closely look at the formula, we can establish the following relationships

    • Higher Dividend Payout => Higher Cost of Equity
    • Lower current market price => Higher Cost of Equity
    • And Obviously, higher growth => Higher Cost of Equity

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