Why are several formulas often used to estimate the cost of common equity instead of the "right" formula?
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1. Why are several formulas often used to estimate the cost of common equity instead of the "right" formula?
The annual rate of return that an investor expects to earn when investing in shares of a company is known as the cost of common equity. That return is composed of the dividends paid on the shares and any increase (or decrease) in the market value of the shares. For example, if an investor expects a 10% return from McDonald's stock and she buys a share at $67.25, her expectation is to receive $6.72 during the year through a combination of dividends (currently $.34 per share during 1998) and the appreciation of the stock price (presumed to be $6.38 to give her the 10% expected return totaling $6.72) during the year (http://www.valuepro.net/approach/equity/equity.shtml).
There are three formulas to calculate the cost of common equity:
1. Use CAPM (uses beta)
2. (GORDON MODEL) The constant dividend growth model - same as DCF method
3. Bond yield - plus - risk premium (http://www.exinfm.com/training/cost_of_capital.doc).
More than one formula is used to address the different return components, mainly because the estimator of some measures will give a biased result depending on the what component you are interested in measuring. Thus, using different models increases the likelihood the estimate of the cost of equity is a reasonable one.
So, let's take a look at what rate of return, in general, an investor should expect from a stock.
For example, the return expected of any risky common stock should be composed of at least three different return components: (1) a return commensurate with a risk-free security (Rf); (2) a return that incorporates the market risk associated with common stocks as a whole (Rm); and (3) a return that incorporates the business and financial risks specific to the stock of the company itself, known as the company's beta.
1) The first measure of return (Rf) relates to what market ...
The solution defines the cost of common equity. It then identifies and explains why several formulas are often used to estimate the cost of common equity instead of the "right" formula. Illustrative examples are also provided.