How do I calculate Cost of Equity?
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How do I calculate Cost of Equity?

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How do I calculate Cost of Equity?

To calculate Cost of Equity (also known as Required Return on Investment or Expected Return) use Capital Asset Pricing Model (CAPM) and follow the steps.

Expected Return = Risk-free Rate + Beta × (Expected Return on Market portfolio – Risk-free Rate)

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= Risk-free Rate + Beta × Market Risk Premium

To use this model we need three inputs (also see BetaEstimationExample excel file): a. Current risk-free rate

As a risk-free rate use the rate of a zero coupon government bond matching the time-horizon of your investment (e.g., short-term investment – 3months government bond; long-term investment – 10year government bond). Where do I get this rate?

UK government bond rates are available at BankOfEngland website (statistics → Interest and Exchange Rates data → Wholesale interest and discount rates → Treasury Bills → Sterling → Annual or Monthly Average).

 

  1. The Market Risk Premium

How do I calculate the market risk premium? 

  • calculate average returns on a stock index (use FTSE100 as a proxy for the UK market, S&P500 as a proxy for the US market) over the period you are interested in (e.g., 3-5 years);
  • calculate average returns on risk-free security over the same period;
  • calculate the difference between two averages and use it as a market risk premium.

 

  1. The beta of stock being analysed

Simple way: In majority of cases beta of the stock could be found on Yahoo Finance, Google

Finance or MorningStar websites. UEA also has paid access to FAME database

(https://fame4.bvdinfo.com/sso/ukfederation) that provides information on beta (see Stock Data → Security & Price Information).

Hard way:

  • Calculate returns on your stock (e.g., Easyjet)
  • Calculate returns on a stock market index (e.g., FTSE100)
  • Using Analysis Tool Pack in Excel: Data → Data Analysis → Regression. Use Returns on your stock (Easyjet) as Input Y and Returns on the market index (FTSE 100) as Input X. How do I read regression output?

We are not interested in Intercept (also known as Jensen’s alpha), Coefficient for (X Variable 1) is beta we were looking for.

Once we have all three components we could calculate the cost of equity.

 

Example: Easyjet

NOTE: I use annualized numbers. All calculations are available in BetaEstimationExample excel file. Annualized Risk-free rate = 4.41%

Beta = 0.98 (benchmark is FTSE250)

Annualized Expected Return on Market Portfolio = 11.99%

Expected Return = Risk-free Rate + Beta × (Expected Return on Market portfolio – Risk-free Rate)

= 4.41% + 0.98 × (11.99% – 4.41%) = 11.84%

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