cost of equity
The return required by equity investors to compensate for the risk of owning a company's stock, used in calculating WACC and evaluating investment decisions.
Example
“Using CAPM, the analyst calculated a 12% cost of equity for the tech startup given its high beta.”
Memory Tip
COST OF EQUITY = what shareholders demand to invest. Higher risk = higher required return.
Why It Matters
Understanding cost of equity helps you evaluate whether an investment opportunity provides adequate compensation for the risk you are taking. When considering stocks or investment opportunities, knowing the required return helps you decide if the potential gains justify the risk involved in your portfolio.
Common Misconception
Many people think cost of equity is simply the current stock price or dividend yield, but it actually represents the minimum return an investor needs to justify holding that stock rather than investing in a safer alternative like government bonds.
In Practice
If a company has a cost of equity of 10 percent and you expect the stock to return only 7 percent annually, you should not invest because you are not being adequately compensated for the risk. Conversely, if you expect 12 percent returns, the investment makes sense because it exceeds your 10 percent required return threshold.
Etymology
COST (required return) OF EQUITY (ownership). The COST (required return) demanded by EQUITY investors.
Common Misspellings
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Related Terms
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See Also
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