How do you calculate the cost of equity for a startup? |
Posted: February 6, 2023 |
The cost of equity is an essential parameter for a startup, especially if they are willing to take the risk. The equity cost measures how much a company needs to earn from an investment or project. It is a benchmark, the bare minimum return any investor of that particular company would expect. When a company decides to invest in a company or a project, it wants to ensure the investment gives a higher return than what it usually would get by investing elsewhere. The cost of equity is the minimum return the company needs to meet its expectation and make the investment worthwhile. This article acts as a startup guide for anyone just starting and wants to ensure they understand the terrain perfectly before walking forward. What is the cost of equity:The cost of equity is a benchmark or a bare minimum amount that one can achieve as a return from investment to meet the expectations of investors and shareholders. Cost of equity calculator vs. startup equity calculatorThe startup equity calculator calculates the equity of the status, which is the overall valuation of your business or your company. At the same time, the cost of equity calculator calculates the minimum expected return on investment of a company that can make the investment worthwhile for the investors. Both are entirely different, but it is important to note that the cost of equity helps determine the equity valuation of a company. Methods for Calculating Cost of EquityBefore knowing how to calculate the cost of equity, we need to understand the financial models used to calculate it. There are several models, but the capital asset pricing model (CAPM) is the most popular. There is another financial model, which is the Dividend Discount Model (DDM). Capital Asset Pricing Model (CAPM)The capital asset pricing model is a financial theory that states that investors need a higher return to balance and compensate them for holding a risky asset. As per this model, two factors influence the cost of equity. This can be an essential part of a startup guide. The first one is the risk-free rate. This is the minimum return an investor would expect just because he invested. This does not consider the risk. For example, the government treasury bond. It is a risk-free asset, so all other investments are as par as using this as a base. The second factor is the Market risk premium. This means the investor expects more in return because they took a risk while investing in a company's assets. 'The investor has the right to premium for taking a market risk.' There is another factor, which is the 'beta.' 'Beta' represents a stock's systematic risk. Systematic risk would mean immediate or market risk due to market movement. Like startup equity calculators, several cost equity calculators are available online. You can take the help of these or you can find it out yourself. As per this financial model, The cost of equity= Risk-Free Rate of Return + Beta × (Market Rate of Return – Risk-Free Rate of Return) Example: If company A trades at a 10% rate of return, and the beta is 1.1, which is a fair number considering the market is a little more volatile than usual, the risk-free rate is 1%, then, as per the CAPM model, Cost of Equity = Risk-Free Rate of Return + Beta × (Market Rate of Return – Risk-Free Rate of Return) Which is, 1+1.1 × (10-1) = 10.9% The Dividend Discount Model (DDM)The Dividend Discount Model (DDM) is a method of valuing the cost of equity by considering its expected future cash flows and discounting them back to the present. The future cash flow is the dividend. Like startup equity calculator, there are several cost of equity calculators that can help determine the cost of equity. You need to opt for the financial model of your choice before typing in the numerical values of the factors. As per the DDM, The Cost of Equity = (DPS ÷ CMV) + GRD. Note: DPS stands for dividends per share. CMV stands for Current Market Value. GRD stands for the growth rate of dividends. How to choose a financial model?An essential part of a startup guide would be the things to consider while choosing a financial model. The first thing is the purpose of the calculation. For example, the Capital Asset Pricing Model (CAPM) is commonly useful for determining the cost of equity in a more theoretical sense. The Dividend Discount Model is useful for determining a company's intrinsic value. Data availability will also play an important role. Significance of cost of equity:The cost of equity is a very significant parameter. In any startup guide, the essential thing is raising funds. Before raising funds, you have to quantify your company or business. This is possible by determining the cost of equity. The cost of equity will not only help raise funds but also has so many practical uses, for example, the company's valuation. With the help of various financial models, one can use the cost of equity to determine the valuation of a company's stocks, which is fair. The cost of equity can also be a startup guide in itself. It can be helpful during capital budgeting. With the help of the cost of equity, the company can determine which projects and ventures give higher returns and make their financial choices accordingly. Companies can also compare their actual return to the cost of equity to evaluate the performance of their equity investments. You can evaluate how low and what things can be done to increase the returns if it is lower. Conclusion:It is essential to keep the cost of equity as balanced as possible by regularly assessing it and understanding the factors influencing it. Generally speaking, the lower the cost of equity, the better it is to raise funds as the risk becomes very low, so many investors would want to invest in your stocks, but it is also important not to make it too low. If the cost of equity is too low, the company has low growth potential or is stable and not growing. A low cost of equity also means the investors need to be more confident in the company.
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