Cost of Equity
The cost of equity is the return a company's shareholders require to hold its shares given the risk — the rate their expected cash flows are discounted at, and the hurdle any use of their capital must clear. It is estimated, not observed: the risk-free rate plus an equity premium scaled by beta, plus premiums for size and illiquidity; for a private fintech it lands between 12% and 20%.
- Also known as
- Required return on equity, Equity discount rate, Ke
- Used at
- discounted cash flow valuations (as the equity discount rate, or inside the weighted average cost of capital), investment appraisal, bank valuation (where the return on equity against the cost of equity sets the price-to-book multiple)
- Binding
- no — an estimate; but a fairness opinion or an impairment test that uses it is challenged on it
- Typical estimate (CAPM)
- risk-free rate (a government bond yield, 3–4.5% in 2024–2025) + beta × equity risk premium (5–6%); a listed payments company with a beta of 1.2 lands near 10–11%; a private company adds a size premium (2–4%) and a specific-risk premium, reaching 14–18%
- Typical bank use
- a bank earning a return on tangible equity above its cost of equity trades above book value; below it, below book — which is the whole valuation of bank M&A in one line
- Parties
- analysts, valuers, boards and investors; everyone with a different number for the same company
How the cost of equity works in practice
Shareholders are last in line and bear the most risk, so they require the highest return. The question is how much. The capital asset pricing model gives the standard answer: start from what a risk-free investment pays, add the extra return the stock market has historically paid over it, scaled by how much this company's shares move with the market (its beta). A beta of 1.0 is average risk; a fintech whose shares swing twice as hard has a beta of 2.0 and a cost of equity twice as far above the risk-free rate. Private companies have no beta of their own, so valuers borrow the listed comparables' and add premiums for size, illiquidity and the risks a single company carries.
The number then does work. In a DCF it discounts the equity cash flows — or, blended with the after-tax cost of debt, discounts the enterprise cash flows as the WACC. In a bank valuation it is the yardstick: a bank earning 14% on tangible equity with a 10% cost of equity is worth about 1.4× book; one earning 8% is worth 0.8×. In an investment case it is the hurdle a project or an acquisition must beat.
For a fintech the honest use is as a range and a sensitivity. A valuation that changes by half when the cost of equity moves from 12% to 15% is telling the reader where the uncertainty is, and a single number to two decimal places is telling them nothing.
Example
An analyst estimates the cost of equity of a private payments company. Risk-free rate: 3.5% (a ten-year government bond). Equity risk premium: 5.5%. Beta from four listed payment processors, unlevered and re-levered for the company's debt: 1.3. CAPM: 3.5% + 1.3 × 5.5% = 10.7%. Size premium for a company a tenth the size of the comparables: 3%. Specific risk — one sponsor bank, two large merchants: 2%. Cost of equity: 15.7%, and a range of 13–18%. In the DCF, €12m of equity cash flow growing 4% a year is worth €103m at 15.7%, €133m at 13% and €86m at 18%. The investment committee reads the range and asks what would move the sponsor-bank risk out of the premium and into the price: a second sponsor, signed before completion.
Common mistakes
- A cost of equity to two decimal places from inputs that are estimates to the nearest per cent. - Using a listed comparable's beta for a private company without the size and illiquidity premiums. - Confusing the cost of equity with the cost of capital; the WACC blends in debt and is lower. - A risk-free rate from a different currency than the cash flows. - Valuing a bank on a DCF of dividends with a cost of equity below the return the bank actually earns, and calling the result conservative.