Thinking about Cost of Equity

We were recently working on the Valuation of a large listed steel company where we derived the cost of equity for the company as 11.34% where a team member suddenly asked – does this mean the company will earn 11.34% on the investment?

The traditional view of looking at cost of equity (K_e) has been that markets are priced efficiently and calculating K_e from the CAPM model gives an estimate of what investors would expect to make in a company. However, it is only the return an investor can reasonably expect to make in the long run for the company. This comes with the caveats that the stock needs to be correctly priced and CAPM is the right model for it. But this might not be the best way of thinking about K_e.

Here’s another way to look at K_e. 11.34% is the return an investor needs to make on the company to break even. But why does an investor need to make 11.34% when the risk-free rate is much lower. We need to make 11.34% because this is a riskier investment. So if another investor comes and estimates that the company will make 12% or 13% returns on the stock, then this becomes a good investment opportunity. The 11.34% is our benchmark and if the stock performs better, then it is a good investment for us.

From the standpoint of the management of the company, 11.34% becomes the hurdle rate return to make investors break-even, not exceed expectations. What is the company is unable to achieve this benchmark return? The company will not go bankrupt. But the stock prices will drop and if they drop for a long enough period, perhaps the stock holders will get angry enough to replace the management. Simultaneously, the expected K_e would also drop to meet more realistic levels. This view of cost of equity truly ties the notion that the company belongs to its stockholders and not its management.