Cost of Equity Calculator

Looking to calculate the cost of equity for a firm? Finance theory has a handful of equations to help, the most popular probably being:

Rf + β (Rm – Rf)

How about a calculator? I learned a little javascript just for you!

Rf: Risk-Free Rate (%)
β: Beta
Rm – Rf: Equity Risk Premium (%)

%


You can grab a proxy for the risk-free rate (Rf) here. Just read the number out of the yield column corresponding to your holding period.

Risk-Free Rates
http://finance.yahoo.com/bonds

How about the equity risk premium (Rm – Rf)? Big debate as to whether to use implied or historical estimates, and over what time frame. Maybe you get a number as low as 2% or as high as 8%.

Beta can be looked up on any financial website. What is not reported is the standard error of their estimate though. It’s often huge, such that if their regression said β = 1.0, they can’t say it’s not really as low as 0.5 or as high as 1.5.

So using our equation, and the fact that right now Rf≈0%, the cost of equity for a β=1 company may be:

As low as… 0.5 x 2% = 1%
Or as high as… 1.5 x 8% = 12%

Useless.

Fundamentalists follow the letter of the law. They use the handed-down prescription. If we secretly replace their Power Smoothie with a Mango Daquiri, we might see them loosen up and only round β to one decimal place.

Creative Thinkers respect the spirit of the law, but aren’t afraid to use their judgement. Maybe a higher beta firm often has riskier operations, but let’s not judge this book too quickly by its cover…

Now I know my javascripting is amazing, and you’re welcome to revisit and use the equation box as often as you like. But might I recommend an alternative free cost of equity app that you can keep in your pocket?

Real Cost of Equity
Thank you, Bruce Greenwald

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