The Cost of Equity is an investment return which a company offers its shareholders in compensation for their income stream and taking risk of investment with a company.
Cost of Equity which is based on the constant dividend growth model is mathematically expressed here.
Cost of Equity = [Dn ÷ P] + G
Where;
Dn = dividend per share to be paid next year
P = average stock price in the year the latest dividend paid
G = expected growth of dividend on next year
A next year dividend is mathematically expressed like this.
Dn = Dc × (1 + G)
Where;
Dc = dividend per share for present year
Therefore,
Cost of Equity = [Dc × (1 + G)] ÷ P + G
The Cost of Equity is tricky to determine since it depends on an estimate of how the company will perform in the future. The best way to estimate of the company dividend growth (G) is to study past financial performance overall economic trend and other factors. It becomes a judgment call for each individual investor to take a calculated risk on “G”.
Example: Determine cost of equity based on the given information.
James oilfield services Ltd has a share price of 50$/share and this year the company pay investors a dividend of 1.95 $/share. The company has a strong portfolio in term of work in the future with several oil companies. The company expected dividend growth rate for next year is 10%.
Cost of Equity = [Dc × (1 + G)] ÷ P + G
Where;
Dc = 1.95 $/share
G = 10 %
P = 50 $/share
Cost of Equity = [1.95 × (1 + 0. 1)] ÷ 50 + 0.1
Cost of Equity = 0.1429 (14.29 %)
Reference Book
Thomas Sowell (2007) Basic economics: A Common Sense Guide to the Economy, New York, New York, USA: Basic Books.
