{"concept":{"id":75,"slug":"cost-of-equity","term":"Cost of equity","shortDefinition":"The minimum return a company's shareholders demand for taking on the risk of investing in it -- not a book figure on the balance sheet.","longDefinition":"Cost of equity is the minimum return a company's shareholders demand for taking on the risk of investing in it -- a percentage, not a monetary figure. It shouldn't be confused with equity itself, already covered in Level 2: equity is a book value on the balance sheet -- what's left of assets after subtracting liabilities -- while cost of equity is a required rate of return, a completely different magnitude despite the similar names. The most widely used model for estimating it is CAPM (Capital Asset Pricing Model): it starts from the risk-free rate -- what a virtually risk-free investment would yield -- and adds a market risk premium, adjusted by the stock's beta, which measures how much its returns move relative to the market as a whole. The result depends on which risk-free rate, risk premium, and beta are used -- it's a reasoned estimate, not an exact, unquestionable figure."},"relations":{"requirement":[],"contrast":[],"related":[{"concept":{"id":12,"slug":"risk","term":"Risk","shortDefinition":"Uncertainty about an investment's future outcome: the possibility that the actual result will differ from the expected one -- not merely the possibility of losing money.","longDefinition":"An investment's risk is not \"the probability of losing money\" in a strict sense, but the uncertainty about whether the actual result will match the expected one -- that result can be worse than expected, but also better. No investment is completely free of risk, not even holding cash, which carries the risk of losing purchasing power to inflation. Risk isn't uniform across asset types: it varies by issuer, term, and the nature of the instrument. It's directly tied to expected return -- see `return` -- and one way of measuring it, though not the only one, is volatility."}}],"calculatedBy":[{"concept":{"id":76,"slug":"wacc","term":"WACC","shortDefinition":"The precise calculation of the cost of capital: the weighted average of the cost of debt and the cost of equity, according to each one's weight in the company's financing.","longDefinition":"WACC (Weighted Average Cost of Capital) is the precise specialization of the cost of capital, already covered in general terms in Level 2 and used that way by ROIC and DCF. WACC combines the after-tax cost of debt and the cost of equity, each weighted by its relative share in the company's total financing: the greater the proportion of debt versus equity, the more the average leans toward debt's cost -- generally lower -- and vice versa. The result is a single discount rate, but not an exact, unquestionable figure: it depends directly on the estimates of its two components -- particularly the cost of equity, sensitive to CAPM's assumptions -- and on the financing weights used. It's the figure ROIC compares against business returns, and that DCF uses to discount its future flows, now calculated precisely instead of estimated in general terms."}}]},"curricularPosition":[{"id":62,"moduleId":22,"slug":"what-is-the-cost-of-equity-and-how-is-it-estimated-with-capm","title":"What is the cost of equity and how is it estimated with CAPM?","summary":"You know what the cost of equity is, why it isn't the same as equity itself, and how it's estimated with CAPM.","bodyMarkdown":"## Objectives\n\nBy the end of this lesson you know what the cost of equity is, why it isn't the same as equity itself, and how it's estimated with CAPM.\n\n## Content\n\nThe second component of cost of capital is cost of equity: the minimum return a company's shareholders demand for taking on the risk of investing in it. It's easy to confuse it with equity, already covered in Level 2 -- both names mention \"equity\" -- but they're magnitudes of a completely different nature. Equity is a book value: a balance sheet figure, what's left of assets after subtracting liabilities. Cost of equity is a required rate of return: a percentage, not a monetary figure. They aren't the same magnitude under a different name.\n\nThe most widely used model for estimating cost of equity is CAPM (Capital Asset Pricing Model). CAPM isn't a magnitude in itself -- it's the method used to estimate this rate, just as the accrual basis is the method used to build the income statement. It starts from three elements. The first is the risk-free rate: the return on a virtually risk-free investment, like a solvent country's long-term government debt. The second is the market risk premium: the extra return investors demand for investing in equities instead of that risk-free asset, precisely to compensate for the risk -- the uncertainty about the future outcome, already covered in Level 1 -- they take on by doing so. The third is the stock's beta: a measure of how much that specific stock's returns move relative to the market as a whole -- a beta above one indicates the stock amplifies market movements, and a company with a beta like that rightly demands a higher risk premium.\n\nCAPM combines these three elements: cost of equity is the risk-free rate plus the market risk premium, adjusted by the stock's beta. But the result isn't an exact, unquestionable figure -- it depends on which risk-free rate, which risk-premium period, and which beta estimate are used. Two reasonable analysts can arrive at different estimates of the same company's cost of equity, without either necessarily being wrong.\n\nThe next lesson combines the cost of debt and the cost of equity, weighted by their relative share in the company's financing, to obtain the WACC.\n\n## Example\n\nIf the risk-free rate is 3%, the market risk premium is 5%, and a stock's beta is 1.2, the cost of equity estimated with CAPM is 3% + 1.2 × 5% = 9%. With a beta of 0.8, that same calculation would give 3% + 0.8 × 5% = 7% -- the same company, a different cost of equity, just from having a different sensitivity to the market.\n\n## Common mistakes\n\n- Confusing cost of equity with equity itself because of the similar names -- one is a required rate of return, the other is a balance sheet book figure.\n- Treating the CAPM result as an exact, definitive figure, without accounting for the fact that it depends directly on the risk-free rate, risk premium, and beta estimates used.\n\n## Summary\n\nCost of equity is the minimum return a company's shareholders demand, not a book figure -- it shouldn't be confused with equity. CAPM is the most widely used model for estimating it: risk-free rate plus market risk premium, adjusted by the stock's beta. The result is a reasoned estimate, sensitive to its assumptions, not an unquestionable figure.\n\n## Self-check\n\nWhy isn't cost of equity the same as equity, despite the similar names?\n\nWhat three elements does CAPM combine to estimate cost of equity, and why isn't the result an exact figure?","bodyHtml":"<h2>Objectives</h2>\n<p>By the end of this lesson you know what the cost of equity is, why it isn't the same as equity itself, and how it's estimated with CAPM.</p>\n<h2>Content</h2>\n<p>The second component of cost of capital is cost of equity: the minimum return a company's shareholders demand for taking on the risk of investing in it. It's easy to confuse it with equity, already covered in Level 2 -- both names mention &quot;equity&quot; -- but they're magnitudes of a completely different nature. Equity is a book value: a balance sheet figure, what's left of assets after subtracting liabilities. Cost of equity is a required rate of return: a percentage, not a monetary figure. They aren't the same magnitude under a different name.</p>\n<p>The most widely used model for estimating cost of equity is CAPM (Capital Asset Pricing Model). CAPM isn't a magnitude in itself -- it's the method used to estimate this rate, just as the accrual basis is the method used to build the income statement. It starts from three elements. The first is the risk-free rate: the return on a virtually risk-free investment, like a solvent country's long-term government debt. The second is the market risk premium: the extra return investors demand for investing in equities instead of that risk-free asset, precisely to compensate for the risk -- the uncertainty about the future outcome, already covered in Level 1 -- they take on by doing so. The third is the stock's beta: a measure of how much that specific stock's returns move relative to the market as a whole -- a beta above one indicates the stock amplifies market movements, and a company with a beta like that rightly demands a higher risk premium.</p>\n<p>CAPM combines these three elements: cost of equity is the risk-free rate plus the market risk premium, adjusted by the stock's beta. But the result isn't an exact, unquestionable figure -- it depends on which risk-free rate, which risk-premium period, and which beta estimate are used. Two reasonable analysts can arrive at different estimates of the same company's cost of equity, without either necessarily being wrong.</p>\n<p>The next lesson combines the cost of debt and the cost of equity, weighted by their relative share in the company's financing, to obtain the WACC.</p>\n<h2>Example</h2>\n<p>If the risk-free rate is 3%, the market risk premium is 5%, and a stock's beta is 1.2, the cost of equity estimated with CAPM is 3% + 1.2 × 5% = 9%. With a beta of 0.8, that same calculation would give 3% + 0.8 × 5% = 7% -- the same company, a different cost of equity, just from having a different sensitivity to the market.</p>\n<h2>Common mistakes</h2>\n<ul><li>Confusing cost of equity with equity itself because of the similar names -- one is a required rate of return, the other is a balance sheet book figure.</li><li>Treating the CAPM result as an exact, definitive figure, without accounting for the fact that it depends directly on the risk-free rate, risk premium, and beta estimates used.</li></ul>\n<h2>Summary</h2>\n<p>Cost of equity is the minimum return a company's shareholders demand, not a book figure -- it shouldn't be confused with equity. CAPM is the most widely used model for estimating it: risk-free rate plus market risk premium, adjusted by the stock's beta. The result is a reasoned estimate, sensitive to its assumptions, not an unquestionable figure.</p>\n<h2>Self-check</h2>\n<p>Why isn't cost of equity the same as equity, despite the similar names?</p>\n<p>What three elements does CAPM combine to estimate cost of equity, and why isn't the result an exact figure?</p>","sortOrder":2,"readingMinutes":9,"difficulty":"Intermedio","url":"/en/academy/valuation/wacc-and-cost-of-capital/what-is-the-cost-of-equity-and-how-is-it-estimated-with-capm"}],"graphSummary":{"root":{"type":"concept","id":"75","depthFromRoot":0,"entity":{"type":"concept","slug":"coste-del-capital-propio","term":"Coste del capital propio","excerpt":"Rentabilidad mínima que exigen los accionistas de una empresa por el riesgo de invertir en ella, no una cifra contable del balance."}},"depth":1,"returnedNodes":1,"truncated":false,"hasCycle":false,"nodes":[{"type":"concept","id":"75","depthFromRoot":0,"entity":{"type":"concept","slug":"coste-del-capital-propio","term":"Coste del capital propio","excerpt":"Rentabilidad mínima que exigen los accionistas de una empresa por el riesgo de invertir en ella, no una cifra contable del balance."}}],"edges":[]},"relatedNews":[],"relatedEntities":[]}