If you’re considering whether to take out a loan or bring in investors, or you’re wondering if it’s worth putting money into a new project, understanding the cost of equity could help you decide.
The cost of equity is the return investors expect for putting their money into your business. Knowing this cost of equity can help you compare funding options, plan for growth and potentially even negotiate better deals.
The cost of equity can vary widely depending on your industry, business stage and risk profile. Fortunately, calculating the cost of equity is relatively straightforward.
In this article we’ll guide you through the cost of equity formula, explain what it means for your business and show you how to use it, whether you’re starting out or scaling up.
In a nutshell: The cost of equity is the return investors want for owning a share of your business. It’s essentially the price your business pays to attract and retain investment capital. Understanding how to calculate and apply the cost of equity can help you plan for long-term success.
What is the cost of equity?
The cost of equity represents the return that investors want in exchange for putting their money into your company. It’s essentially the compensation for their confidence and capital.
Unlike debt, you don’t need to make any scheduled repayments. The cost of equity is instead reflected in your share price and the profitability of your business.
For newer businesses, the cost of equity might feel a little abstract. But it’s a useful tool that can help you make future plans, even if you’re not ready for investors yet. It shows you what investors will expect when you are ready and how the choices you make now (eg building a strong credit score or managing cash flow) can lower that cost later.
For more established businesses, it’s a way to compare equity funding with other options, like business loans or revenue-based financing. And in regulated sectors, like energy or water, it’s often set by industry standards.
Why is the cost of equity important?
The cost of equity is a valuable tool because it can be used to influence important decisions about how you fund and grow your business.
For example, if you’re weighing up debt financing versus equity financing, the cost of equity can help you compare the two. Debt financing might seem cheaper at 7% interest, but if your cost of equity is 9%, giving away shares could still be the smarter move if it means less risk or more flexibility.
Calculating cost of equity can also influence how you value your business. A lower cost of equity can make your business look more attractive to investors, while a higher one might make loans or grants a more attractive proposition.
Similarly, if you’re planning to expand your business, knowing the cost of equity can help you decide which projects are worth pursuing. For example, if a new venture won’t deliver a return higher than your cost of equity, it might not be worth the investment.
What is the cost of equity formula?
There are two main ways to calculate the cost of equity: the Capital Asset Pricing Model (suitable for most businesses) and the Dividend Capitalisation Model (if you pay dividends).
Capital Asset Pricing Model
The most common way to calculate the cost of equity is with the Capital Asset Pricing Model (CAPM).
Cost of equity = risk-free rate + (beta * equity risk premium)
Here’s how it breaks down:
Risk-free rate: This is the return investors could get from a ‘safe’ investment, like UK government bonds (10 year bonds were 4.4% at the time of writing).
Beta: Beta measures how volatile your business is compared to the market. A beta of 1 means your business moves with the market. Higher than 1? You’re more volatile. Lower? You’re steadier. For example, technology companies tend to have a beta higher than 1.
Equity risk premium: This is the extra return investors expect for taking on riskier stocks instead of safer bonds. For example, if stocks were estimated to return 10% and bonds 4%, the risk premium would be 6%.
Here’s how a small retail business might calculate their cost of equity:
Risk-free rate: 3%
Beta: 1.2
Equity risk premium: 5%
Cost of equity = 3% + (1.2 * 5%) = 9%
That means investors would expect a 9% return to justify putting their money into the retail business.
Dividend Capitalisation Model
If your business pays dividends, you can also use the Dividend Capitalisation Model (sometimes called the Dividend Discount Model or Gordon Growth Model). This model assumes that the value of your shares is based on the dividends you pay now and in the future.
Here’s how it breaks down:
Dividend per share: The amount you pay out to shareholders for each share they own
Current share price: The price of one share in your business today
Dividend growth rate: How much you expect your dividends to grow each year, as a percentage
Here’s how a national retailer might calculate their cost of equity:
Dividend per share: £0.50
Current share price: £10
Dividend growth rate: 2%
Cost of equity = (£0.50 / £10) + 2% = 5% + 2% = 7%
That means investors would expect a 7% return to justify putting their money into the retail business.
This model only works if your business pays regular dividends and you can estimate their growth rate. It’s less common for start ups or high-growth businesses, which often reinvest profits rather than paying dividends.
What factors influence your cost of equity?
Your cost of equity isn’t set in stone. It changes based on your business, the economy and even how transparent you are with investors.
Things that can increase your cost of equity:
High volatility (eg a tech start up in a fast-changing market)
Economic uncertainty or industry risks (eg Brexit-related trade disruptions or supply chain issues)
Poor financial health or inconsistent profits
Things that can decrease your cost of equity:
A strong track record and stable revenue
A low-beta industry (eg a regulated utility like water or energy)
Clear, honest communication with investors (eg providing regular financial updates and realistic growth forecasts)
How can the cost of equity be used in financial decisions?
The cost of equity can be used at every stage of your business.
If you’re just starting out (0-6 months)
Pick the cheapest funding: Compare the cost of a business loan (eg 10%) with the cost of giving up equity (eg 15%) – if equity’s more expensive, a loan might be the better choice
Set fair expectations: Show investors why their expected return matches your business’s risk and growth potential
Focus on profitable projects: Before spending on marketing or hiring, check if the expected return beats your cost of equity
If you’re growing (6-12 months)
Decide on big purchases: If buying equipment or stock won’t earn more than your cost of equity, it might not be worth it
Negotiate better deals: If an investor wants a 20% return but your cost of equity is 12%, you could use that to push for better terms
Choose between loans and investors: If loans are cheaper than equity, consider opting for debt – unless the investor offers extra benefits, like expertise
If you’re established (12+ months)
Balance your funding: If equity’s more expensive than debt, consider using more loans (safely) to lower your overall funding costs
Evaluate expansions or acquisitions: Only invest in new projects if they earn more than your cost of equity
Value your business: Knowing your cost of equity helps you justify your business’s worth to investors or buyers
Check underperforming assets: If a project isn’t earning more than your cost of equity, it might need a review
Over 30% of UK business investment comes from firms that use hurdle rates (minimum returns they expect from projects). If you’re in that group, your cost of equity can act as the baseline for setting those rates.
Cost of equity vs cost of debt
Cost of equity and cost of debt both measure how much it costs to fund your business. But they work very differently.
The cost of debt is what you pay in interest on loans. It’s usually lower than the cost of equity and you can deduct the interest from your taxes. But you have to pay it back, no matter how your business performs.
The cost of equity is usually higher because investors take on more risk – there’s no guarantee they’ll see a return. But there’s also no obligation to pay them back if things go wrong. And unlike debt, equity doesn’t put a strain on your cash flow with regular repayments.
Here’s a quick comparison for a business deciding between a 7% loan and a 12% cost of equity:
| Cost of debt | Cost of equity |
|---|
| | |
| | |
| | |
| | |
Wrapping up
The cost of equity is a powerful tool for planning and growth. It helps you compare funding options, attract investors and make smarter decisions about where to put your money.
If you’ve been trading for less than six months, you could focus on building your financial health to lower your future cost of equity
If you’re 6-12 months in, you could use it to compare loans, grants and equity as you plan for growth
If you’re an established business, cost of equity could be a key part of optimising your funding mix and evaluating big projects
Remember, the cost of equity isn’t fixed. As your business grows and becomes more stable, you can bring it down and make your business even more attractive to investors.
FAQs
What’s a good cost of equity for a small UK business?
For most UK small businesses, a cost of equity in the 8-12% range is typical. Regulated or low-risk sectors might see lower rates and high-growth or riskier businesses could see higher rates.
Can I calculate cost of equity if my business doesn’t pay dividends?
Yes. The CAPM formula (see above) works for any business, even if you don’t pay dividends. It’s based on investor expectations, not actual payouts.
How often should I update my cost of equity calculation?
Aim to review it at least once a year, or whenever there’s a big change in your business, the economy, or interest rates.
Why is my cost of equity higher than my cost of debt?
Equity is riskier for investors, so they expect a higher return. Debt is secured and has tax benefits, which makes it cheaper.
How does cost of equity affect my business valuation?
A lower cost of equity typically increases your business’s value because it means future profits are worth more today. A higher cost of equity does the opposite.
What’s the difference between cost of equity and WACC?
Cost of equity is just one part of your Weighted Average Cost of Capital (WACC), which also includes the cost of debt.
Where can I find the risk-free rate and beta for my industry?
The risk-free rate is based on UK government bond yields. Beta varies by industry, but you can find benchmarks in financial reports or tools like Bloomberg.
How do investors use cost of equity to value my business?
Investors look at your cost of equity to decide how much your business is worth and calculate the value of your future profits. The lower your cost of equity, the more valuable your business looks to them.
Does cost of equity change over time?
Yes. It can go up or down based on your business performance, economic conditions and investor sentiment.
Photo by Carrie Allen www.carrieallen.com on Unsplash
