How to calculate the cost of equity

Hi,

Good question! In interviews, they’ll often expect you to know how to calculate the cost of equity, and yeah, the most common way to do it is by using the CAPM (Capital Asset Pricing Model). The formula is:

Cost of Equity = Risk-Free Rate + Beta × (Market Return - Risk-Free Rate)

Here’s how it breaks down:

• The Risk-Free Rate is usually the yield on long-term government bonds (like U.S. Treasuries).
• Beta measures the stock’s volatility compared to the market. You can usually find this on financial websites or company reports.
• The Market Risk Premium is the difference between the expected return of the market and the risk-free rate. In practice, it’s typically around 5-6%, but it can vary.

CAPM is the go-to method because it’s straightforward and shows you understand the relationship between risk and return. But it’s not the only way. In some cases, especially if you’re discussing startups or companies with no historical beta, you might mention:

• The Dividend Discount Model (DDM) if the company pays consistent dividends.
• Using industry comparables to estimate the required return if you don’t have a reliable beta.

Still, unless the interviewer specifically asks about alternative methods, stick with CAPM. It’s the standard for a reason, and most interviewers expect you to know it inside and out.

Good luck with your interview prep!

To calculate the cost of equity, the most common method is the Capital Asset Pricing Model (CAPM), using the formula:

Cost of Equity = Risk-Free Rate + Beta × (Market Return - Risk-Free Rate)

Where:

• Risk-free rate is typically long-term government bond yields,
• Beta is the stock’s volatility relative to the market,
• Market Return is the expected market return.

CAPM is generally the standard, but alternatives like the Dividend Discount Model (DDM) or Build-Up Method may be used in specific cases, such as for companies with stable dividends or limited data. In interviews, it’s safe to use CAPM and explain each component clearly.