Below we will explain how to calculate the cost of equity using a real world example. We will be using 3M's 2020 annual report (which can be found here), and market figures to generate the risk free rate and the beta.
Put another way, the cost of equity represents the opportunity cost a shareholder takes by owning one company over other investments with a similar risk (source).
There are two ways of calculating the cost of equity for a company, the dividend capitalization model and the capital asset pricing model (CAPM).
Dividend capitalization model is an easier calculation but requires that a company give dividends to its shareholders.
The capital asset pricing model (CAPM) is a more complex calculation and requires estimating the relative risk of the stock price (beta).
Cost of equity = (D/P) + G
The yearly dividends per share for 3M in the year 2020 was 5.88. This is calculated by adding up the dividend given per share each quarter of 1.47 for the year 2020.
Which share price do we use? Because we're looking at the 2020 annual report we will get the average share price for that year using the weekly closing prices. The average share price for 2020 is 160.0.
The dividend growth rate is the increase, or decrease, in dividends over the years. In this calculation we will use the difference in dividends from the year 2019 to the year 2020. In 2019 the quarterly dividend paid was 1.44. In 2020 the quarterly dividend paid was 1.47.
G = (1.47 / 1.44) - 1 = 0.02 or 2%
Cost of equity = (5.88 / 160.0) + 0.02 = 0.05675 or 5.67%
Cost of equity = RFR + β x MR
The risk free rate, like its name suggests, is the interest rate an investor can get that has zero risk of default. The risk free rate is commonly set at the three month treasury bill interest rate, for US companies, as government treasury bonds are seen as close to risk free as possible.
The average 3 month T Bill for December 2020 was 0.02%.
The beta in this context is a measure of the volatility 3M's stock price has compared to a list of companies in the same sector. Calculating the Beta is a worthwhile exercise to perform manually, however it is something left for a future article (and an exercise for the reader). We will grab the beta from publicly available sources (we used yahoo finance which gives us the 5y monthly beta).
Beta is 0.95.
NOTE: a beta of less than 1 means that the stock is less volatile than the comparison market. i.e. 3M, at a beta of 0.95, is less likely to go up or down than the market we are comparing against.
The market risk, or market risk premium, is the difference between the overall return of the market (like the S&P 500) and the risk free rate. The S&P 500 has had an average approximate return of 10% since 1900 so we will use that figure (source).
MR = 10 - 0.02 = 9.98
Cost of equity = 0.02 + (0.95 x 9.98) = 9.501
As you can see we have arrived at two different results. Estimating the cost of equity is not straight forward and not 100% accurate. The two results we have arrived at here are different from each other and both of these values will differ from the results other analysts may arrive at if they use slightly different values for their inputs.
The main take-away is that, as long as inputs are consistent across companies, we can compare 3M's cost of equity with similar companies in the same sector. The results we get for cost of equity may be very rough but when compared to the rest of the sector using the same measure we can get the relative fitness of 3M.
Problems arise when you try to compare companies across sector and especially across countries (source).
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