Cost of equity

A company's cost of equity is the annual rate of return that an investor expects from a firm in exchange for bearing the risk of owning its shares. The expected return is calculated by adding the dividend yield (the dividend per share divided by current market price of the stock) to any growth rate dividends.

Using a very simple example, we can calculate it as follows. Say you require a rate of return of 10% on an investment in ACME Inc. The stock is currently trading at £10 a share, which means you will want a £1 return on your investment. However, because it pays a dividend of 40p a year, the share price will have to rise 60p in order for you to get that desired return. This 10% return is your cost of equity.