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Cost of equity: this corresponds to the total shareholder return TSR = (Share Price at the end of the period – Share Price at the beginning of the period + Dividend earned during the period) / (Share price at the beginning of the period) that the shareholders would expect to earn when buying stakes in the company (i.e. when providing it with fresh equity). Say you are investing $100 in a share of company A today, you are expecting your share to be worth $110 in 1 year and you are also expecting to receive a $5 dividend. The implicit cost of equity is thus (110+5-100)/100 = 15%.

 

What are exactly the determinants of the cost of equity ? There are two of them:

 

-          the expected TSR when investing in the company: is measured by looking at the past ROEs of the company over the last n years, and computing their arithmetic average.

-          the risk profile of this company: is measured by computing the volatility of the series of the past ROEs of the company over the last n years.

 

Both indicators can be extrapolated by looking at historical data, even though the past might prove to be a very poor indicator of the future (this is the reason why a thorough analysis of the company’s future projects should be undertaken, and would probably yield better predictions than a mere extrapolation of past numbers).

 

Indeed, a company might bring you a very high TSR on average, but with very high fluctuations (so that it may happen that you lose a lot of money with a positive probability). Let’s examine below two different situations; in the first one (Company Risk-Free), the company shows an expected TSR of 5% with no risk at all (based on historical results). In the second case, (Company Risk-Adverse), the TSR is still 5% and the risk is minimal (as measured by volatility). In the last case (Company For-Gamblers), the TSR remains at 5% but the risk is very important.

 

 

 

 

	Expected TSR	Volatility of TSR	Cost of Equity
Company Risk-Free	5%	0	5%
Company Risk-Adverse	5%	0.01	6%
Company For-Gamblers	5%	0.04	11%

 

 

We observe that the riskier the company is, the higher the cost of equity will be (which seems logical since investors will want to be remunerated on the risks that they are going to take). However, how is the cost of equity precisely determined ?

It is not our intention to delve into the complicated details of financial engineering, but essentially, you might remember the few following points:

 

-          If the company is floated on the stock market, the cost of equity can be determined by first deriving the “beta” of the company, which provides a statistical measure of the systematic (aka idiosyncratic) risk incurred by the company, that is to say this part of the risk which cannot be diversified.

 

-          If the company is not floated on the stock market, then you might want to have a look at the cost of equity of companies from the same sector and with a similar capital structure (we will see a little later that a capital structure in which debt is in higher proportion will be expected to bring a higher TSR). Thus, your cost of equity will be determined by peers comparison.