How to Calculate Cost of Equity for a Small Business

Considering building a second location, purchasing a company, or entering a new market? Calculating the cost of equity can ensure your investment pays off. Investors and small business owners use the cost of equity metric to compare future cash flows to investment costs and risks. Understanding your company's cost of equity helps you make better-informed decisions and protect your organization's financial health.

However, cost of equity assumptions are subjective, meaning you may get different results depending on the rates used for calculations. Miscalculations can cause you to miss valuable opportunities or take on unprofitable projects. When in doubt, work with a financial and business valuation expert.

The information in this guide can help you understand how to calculate cost of equity for a small business, the factors affecting equity costs, and how using this metric can improve decision-making, financial planning, and your company’s financial health.

Cost of equity meaning and financial terms to know

Cost of equity refers to the rate of return investors expect when funding a business through equity financing rather than debt financing. Small business owners use this metric to determine whether raising money through investors is more cost-effective than borrowing through loans or credit lines.

Here are terms you may come across when calculating the cost of equity:

• Small business equity: This figure is the net worth of your business after subtracting total liabilities from total assets.
• Risk-free rate (Rf): The expected rate of return from an investment with a low to no risk of default, such as government securities or U.S. Treasury bonds.
• Beta of investment: The value indicates how a company's stock price typically responds to market changes, whether it's resilient or volatile, when the market gains or loses value.
• Expected market rate of return: The average return investors expect from the stock market based on historical data.
• Equity market risk premium (EMRP): In equity financing, this term is often used interchangeably with equity risk premium (ERP). It equals the difference between the expected market return and the Rf.

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Who uses the cost of equity metric?

The cost of equity is a crucial metric for small business owners and executives, investors, financial analysts, and business valuators. When financing a business investment, you have two options: go into debt or use your company's equity. Estimating the cost of equity vs. cost of debt helps you decide how to raise capital.

Stakeholders make a similar decision when determining whether to invest in a company. They want a return that correlates with the initial cost and risk.

Using cost of equity in business valuation models can help assess financial health. Small businesses need accurate business valuations when selling their company or seeking funding.

How cost of equity impacts your investment decisions

After calculating ROI (return on investment) and other performance metrics, let's say you decide to open a second location. The next decision is to fund your project through financing or issuing new equity.

Here’s how calculating the cost of equity guides your decision-making:

• Cost of equity vs. cost of debt: If the cost of equity is higher than the cost of debt, taking out a business loan may be cheaper.
• Risk vs. return: Expansion is riskier when equity costs more because investors demand higher returns. Lower costs suggest a stronger financial position, giving you better access to capital.
• Investor expectations: You can use the cost of equity calculation to set return expectations for investors. If your cost of equity is 10%, you must generate at least a 10% return to meet their demands.

Using cost of equity to evaluate business performance

The cost of equity calculation isn’t just about raising funds; it’s a key performance metric to track your financial efficiency and profitability over time.

Consider these examples:

• Use cost of equity as a benchmark to improve financial planning by forecasting a project's expected return before allocating capital.
• Compare your equity and capital costs to assess whether marketing efforts, new equipment, or expansion projects deliver higher returns than what you put into them.
• Analyze financial statements to see if equity returns are higher or lower than expected and adjust strategies as needed.

Three methods for calculating the cost of equity

There are three formulas for calculating the cost of equity: the capital asset pricing model (CAPM), dividend capitalization, and the build-up method. Review the following guidelines to understand the differences between models and how to estimate the cost of equity using each formula.

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Capital asset pricing model

Publicly traded businesses calculate the cost of equity without dividends using the capital asset pricing model. It measures the expected return based on market risk. Private companies can also use CAPM by estimating their beta.

Here’s what you need to know when calculating cost of equity for private companies:

• CAPM formula: cost of equity = Rf + beta × (expected market return - Rf).
• Estimate a beta value: Use financial databases, Yahoo Finance, or Google Finance to find a beta from a similar company or an industry average beta.

Dividend capitalization model

If your company pays regular dividends to shareholders, you can use dividend capitalization, also called the dividend growth model (DGM). This formula factors the dividends per share, the current stock market value, and the dividend growth rate.

• Formula: cost of equity = (dividends per share / current stock price) + dividend growth rate.

Build-up method for private companies

The build-up method is a cost-of-equity formula for private companies that don’t have a beta value or publicly traded stock. It relies on cost-of-equity assumptions, so working with a qualified professional can help ensure accurate calculations.

Here are the factors affecting cost of equity for small businesses:

• Equity risk premium (ERP): Calculate ERP using current S&P Dow Jones Indices market projections. The formula is ERP = expected market return - risk-free rate.
• Industry risk premium (IRP): Estimate risk levels by looking up industry averages or comparing your business to publicly traded companies.
• Size premium (SP): A 3% to 5% small cap premium generally applies to small businesses, according to Aswath Damodaran, Professor of Finance at the Stern School of Business at NYU.
• Company-specific risk (CSR): This rate is subjective and ranges from 0% to 10% or more based on revenue, market, operations, and additional factors.
• Formula: cost of equity = Rf + ERP + IRP + SP + CSR.

Common mistakes when calculating cost of equity

Getting the cost of equity right helps you make smarter decisions about investments and risk management strategies. However, small business owners often overlook the cost of their own capital, rely on outdated cost of equity estimates, or don’t adjust for changing market conditions. Regularly updating your calculations and accounting for your investments can help you avoid these common mistakes.

Comparing the cost of equity with other costs of capital

The cost of equity is only one part of the capital equation. Understanding cost of equity vs. cost of debt and the difference between WACE and WACC can improve your investment decisions.

In addition to cost of equity, the key components of capital costs include:

• Cost of debt: The interest rate that a company pays on its loans and bonds.
• Weighted average cost of equity (WACE): The blended cost of multiple equity sources, like common stock, retained earnings, and preferred stock.
• Weighted average cost of capital (WACC): The combined costs of debt and equity financing, weighted by their respective proportions in the company's capital structure.

How to apply the cost of equity in investment decisions

Cost of equity is a key piece of information that can help investors make more informed decisions. This metric tells potential investors whether a stock or capital project carries a risk that's aligned with the projected returns.

A high cost of equity indicates that shareholders require a greater return on their investment due to perceived higher risks associated with the company's operations or industry. An investor who sees a high cost of equity may be more selective in their investment choices. They might prioritize projects with higher expected returns to justify the elevated costs and ensure they can recoup their investment.

Emily Heaslip contributed to this article.

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