Stock Valuation

Chapter: 10 Stock Valuation

Section: 8 Cost of Equity

So far, we have assumed the required rate of return on a particular stock investment as given. However, in real life, this cost of equity has to be determined for each stock or company that has to be valued. While there can be many ways to arrive at an appropriate required rate of return, the most commonly used is by the Capital Asset Pricing Model (CAPM). Remember from previous chapters that according to CAPM, the cost of equity for stock i is:

 

E (Ri) = Rf + βi[E(Rm) – Rf]

 

Where:

E (Ri)  = the expected return on asset I
Rf = the risk-free rate of return
E (Rm) = the expected return on the market portfolio
βi =

Cov(Ri, Rm) / Var(Rm), the sensitivity of a security is return to the market’s return

 

Suppose that the beta of stock A is 1.5, the yield on 5-year government bond is 5%, and the expected return on market portfolio is 12%. Therefore, the cost of equity for stock A is:

           

E (RA) = 5%   +  1.5 (12% – 5%)
E (RA) = 15.5%

 

 

 

 

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