Understanding and correctly calculating the cost of equity

Equity costs are a central part of company valuation and directly influence investment decisions and capital structure. But how are they calculated reliably?

This white paper provides an overview of common methods and their respective strengths and weaknesses — from CAPM to DDM.

To determine the cost of equity

Equity costs represent a significant component of a company's capital costs and are a decisive factor in company valuation and investment appraisal. They reflect the return required by investors and significantly influence a company's capital structure decisions.

Methods for calculation

There are various methods for calculating equity costs. In addition to more common methods such as the capital asset pricing model or the Fama French three-factor and five-factor model, models based on the dividend discount model (DDM) have emerged in the recent past.

The dividend discounting model (DDM)

DDM is based on the assumption that the value of a share is equal to the present value of all future expected dividends. The model can be represented in its simplest form, the Gordon Growth Model, by the following formula:

P0 represents the current share price, D1 represents the expected dividend in the following year, rrepresents the cost of equity, and g represents the expected constant growth rate of dividends.

By solving the formula, the following equation can be obtained:

Importance of dividend estimation

When using DDM to estimate equity costs, the choice of dividend estimates is decisive for the reliability of the results. There are various methods for forecasting future dividends — depending on the availability of data and the stability of a company's dividend policy.

The simplest form of DDM is based on the assumption of constant annual dividend growth. This method is often used for mature companies with stable dividend payments (e.g. consumer goods, pharmaceutical, or utility companies) and an established dividend policy.

Sources for dividend estimates

The growth rate of dividends is often either calculated from historical averages or determined on the basis of analyst estimates. Other data sources include company forecasts, dividend policy announcements, and macroeconomic expectations (e.g. inflation, GDP growth).

Some companies publish dividend forecasts several years in advance. There are often external analyst forecasts for larger companies. Data sources for this include Bloomberg, FactSet, Refinitiv (Thomson Reuters), Capital IQ, company reports (earnings calls, annual reports) or research departments of investment banks.

Multi-level DDM models

When a company is in a growth phase or a change in dividend policy is expected, a multi-stage growth model can be used.

This divides the development of dividends into three phases:
▪️ Growth phase: high initial growth rate (e.g. 10% for 5 years)
▪️Transition phase: declining growth
▪️Long-term phase: constant growth based on macroeconomic variables

In this case, the equity costs are determined using a multi-stage DCF calculation.

The Capital Asset Pricing Model (CAPM)

The most frequently used method of calculating the cost of capital is CAPM.

The model calculates equity costs based on a company's systematic risk, measured by the beta factor:

There is r the risk-free interest rate, β the company's beta factor and ERP the market risk premium.

CAPM enhancements: Fama French models

The CAPM was extended by Fama & French (1993, 2015) to include further risk factors. The three-factor model is:

The five-factor model supplements this with two additional components:

Additional factors:
▪️SMB: Small-cap premium
▪️ HML: Value premium
▪️RMW: profitability premium
▪️CMA: investment strategy

Strengths and weaknesses of the models

The CAPM is widely used due to its simple structure. However, studies show that in practice — particularly in small or more volatile companies — it does not always reflect actual return behavior (Fama & French, 1992).

DDM often delivers lower equity costs, which is attributed, among other things, to optimistic analyst estimates (Brav et al., 2005). It is particularly suitable for companies with stable dividends, but is unsuitable for growth-oriented companies.

The Fama-French models are empirically more robust, but significantly more complex in application. In addition, recent studies show that the explanatory strength of individual factors can diminish over time.

Conclusion

Despite its weaknesses, the CAPM remains the most common standard in practice — primarily because of its simplicity. For more precise estimates, the DDM or the Fama-French models can be used in addition, depending on the data situation and company profile. In practice, it is often recommended to combine several methods in order to determine equity costs as reliably as possible.