Cost of equity is the annual return a company's shareholders require for holding its stock — the minimum the firm must earn on equity-funded projects to keep those investors. There are two standard ways to estimate it: the capital asset pricing model (CAPM), which builds the rate up from market risk, and the dividend capitalization model, which backs the rate out of the current share price and expected dividends. CAPM works for any public company; the dividend method only works for stable dividend payers, so most problems lead with CAPM and use dividends as a cross-check.
You need this number whenever you discount equity cash flows. It is the Re input in the WACC formula, and it is the discount rate in a dividend discount model. Get it wrong and every valuation built on top of it is wrong in the same direction.
CAPM says shareholders demand the risk-free rate plus extra compensation for market risk, scaled by how much the stock moves with the market. That scaling factor is beta. This is the version almost every finance course and valuation model uses.
Re = Rf + β × (Rm − Rf)
Re — Cost of equity — the return shareholders require
Rf — Risk-free rate, usually the 10-year Treasury yield
β — Beta — how much the stock moves relative to the overall market
Rm — Expected return on the overall market
Rm − Rf — Market risk premium (also called the equity risk premium)
If a company pays a steady, growing dividend, the market price already tells you what return investors expect. The dividend capitalization model is the Gordon growth model solved for the discount rate: instead of using r to find the price, you start from the price the market is paying and back out r.
Re = (D1 ÷ P0) + g
Re — Cost of equity implied by the current share price
D1 — Expected dividend per share one year from now
P0 — Current share price
g — Expected constant growth rate of the dividend
The risk-free rate (Rf) is the yield on a default-free government bond, almost always the 10-year US Treasury. It is quoted daily on any market data site; exam problems simply hand it to you.
Beta (β) measures how strongly the stock moves with the market. A beta of 1.0 moves with the market, above 1.0 amplifies it, below 1.0 dampens it. In practice you look it up on a data provider such as Yahoo Finance rather than estimating it yourself; it comes from regressing the stock's returns against the market's.
The market risk premium (Rm − Rf) is the extra return the whole stock market is expected to earn over the risk-free rate. Historically it has run about 4 to 6 percent. Read the problem carefully: some give you the premium directly, others give you the expected market return Rm and expect you to subtract Rf yourself.
D1 is next year's expected dividend, not the one just paid. If the problem gives you the most recent dividend (D0), grow it forward one year at g before dividing.
P0 is today's market price per share — the actual quote, not book value per share.
g is the constant rate the dividend is expected to grow forever. Analysts usually estimate it from the historical dividend growth rate or from the sustainable growth rate (return on equity times the retention ratio). It must be a rate the company can plausibly sustain, which in practice means low single digits.
| Step | Calculation | Result |
|---|---|---|
| Risk-free rate (10-year Treasury) | given | 4.3% |
| Beta | given | 0.87 |
| Expected market return | given | 9.8% |
| Market risk premium | 9.8% − 4.3% | 5.5% |
| Risk adjustment | 0.87 × 5.5% | 4.79% |
| Cost of equity — CAPM | 4.3% + 4.79% | 9.09% |
| Current share price (P0) | given | $46.20 |
| Dividend just paid (D0) | given | $1.82 |
| Dividend growth rate (g) | given | 3.4% |
| Next year's dividend (D1) | $1.82 × 1.034 | $1.88 |
| Expected dividend yield | $1.88 ÷ $46.20 | 4.07% |
| Cost of equity — dividend capitalization | 4.07% + 3.4% | 7.47% |
CAPM puts Meridian's cost of equity at 9.09 percent; the dividend model says 7.47 percent. A gap like this is normal, not a mistake. The two formulas use different information: CAPM prices the stock's market risk through beta, while the dividend model only reflects what the current price and payout expectations imply. Here the market is paying $46.20 for a fairly modest dividend stream, which pulls the implied return down. When the estimates disagree, analysts either present the range (roughly 7.5 to 9.1 percent) or average them — the midpoint here is 8.28 percent. On an exam, use whichever method the given inputs support and say which one you used.
The most common CAPM error is multiplying beta by the full expected market return rather than the premium. For Meridian that would add beta times 9.8 percent on top of the risk-free rate, giving 12.83 percent instead of 9.09 percent. Beta scales only the extra return above the risk-free rate — subtract Rf from Rm before multiplying.
Beta changes as a company's business and debt load change. A beta pulled from an old case study, or a levered beta applied to a firm with a very different capital structure, quietly skews the answer. Use a current beta, and if the problem mentions re-levering, that adjustment belongs to the CAPM topic itself — the point here is that beta is an estimate, not a constant.
If D1 is zero, the dividend capitalization formula collapses to just g, which is meaningless. The method also breaks for erratic payers, because g has to be a stable long-run rate. For non-payers and irregular payers, CAPM is the only one of the two methods that works.
Dividing the dividend just paid by the price gives the trailing yield, not the expected one. For Meridian, using $1.82 instead of $1.88 gives a 3.94 percent yield and a 7.34 percent cost of equity — close, but marked wrong. Grow the dividend forward one year first.
Cost of equity is the return shareholders require. Estimate it with CAPM — risk-free rate plus beta times the market risk premium — for any public company, and cross-check with dividend capitalization — expected dividend yield plus growth — when the firm pays a steady, growing dividend. The two estimates rarely match exactly; report the range or the method your inputs support.
Two standard ways. CAPM: take the risk-free rate and add beta times the market risk premium. Dividend capitalization: divide next year's expected dividend by the current share price, then add the dividend growth rate. CAPM works for any public company; the dividend method requires a stable, growing dividend.
No. Cost of equity is what shareholders require; WACC blends it with the after-tax cost of debt, weighted by how much of the firm is financed with each. Cost of equity is one input into WACC, and it is always the higher of the two components because equity holders are paid last.
Use CAPM by default — it works for any public company and is what WACC and DCF problems normally expect. Use the dividend capitalization model when the company pays a steady, growing dividend, either because the problem gives you dividend inputs or as a cross-check on the CAPM number.
Equity is riskier. Lenders get contractual interest payments and stand ahead of shareholders if the company fails; shareholders get whatever is left, which can be nothing. Investors demand a higher expected return for bearing that residual risk, and interest is also tax-deductible while dividends are not.
For large public companies it usually lands between about 6 and 12 percent, driven by the current risk-free rate, the equity risk premium (historically 4 to 6 percent), and the company's beta. Low-beta utilities sit near the bottom of that range; high-beta tech and cyclical firms sit near or above the top.
No. With no expected dividend the formula has nothing to capitalize — the yield term is zero and the result is meaningless. For non-payers, use CAPM instead.
By the FinanceBrain Team · Last verified July 10, 2026 · How we produce and verify articles