The cost of equity represents the return that shareholders expect for investing in a company. It's a cornerstone of valuation, especially when calculating the Weighted Average Cost of Capital (WACC).

One of the most commonly used tools to estimate this return is the Capital Asset Pricing Model (CAPM).

$\text{Cost of Equity} = R_f + \beta \times (R_m - R_f)$

Where:

• $R_f$ - risk-free rate (typically government bond yield);

• $\beta$ - beta, a measure of the stock's volatility relative to the market;

• $R_m$ - expected market return;

• $(R_m - R_f)$ - market risk premium.

This formula reflects that investors demand a return equal to:

1. A safe baseline (risk-free rate);

2. Plus compensation for risk (beta times market risk premium).

• Risk-Free Rate: based on secure government bonds (e.g., 10-year U.S. Treasury);

• Beta: indicates how volatile a stock is compared to the broader market;

  • $\beta > 1$: more volatile;

  • $\beta < 1$: less volatile.

• Market Risk Premium: the extra return investors expect from the stock market over risk-free assets (usually estimated around 5–7%).

Real-World Example

If:

• Risk-free rate = 3%;

• Beta = 1.2;

• Market return = 8%.

Then:

CAPM provides a structured way to estimate the return investors expect for taking equity risk. It's not perfect—it assumes markets are efficient—but it's the industry standard for a reason.