# Cost of Equity: Formula, Models, and How to Calculate It

Published: 2026-03-02
Author: Warren Team
URL: https://www.heywarren.com/blog/cost-of-equity-equation

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The cost of equity is the return that equity investors require to compensate them for the risk of owning shares in a company. Unlike the cost of debt (which is the explicit interest rate on borrowings), the cost of equity is an implicit, market-derived rate, there is no invoice for it. Instead, it represents the minimum return a company must generate for its shareholders to be willing to hold the stock rather than sell and invest elsewhere. The cost of equity is a critical input in the [Weighted Average Cost of Capital](/blog/how-to-calculate-weighted-cost-of-capital) (WACC), which in turn drives discounted cash flow (DCF) valuation, capital budgeting decisions, and the benchmark for measuring whether a business creates or destroys economic value.

## The CAPM Formula: The Standard Approach

The most widely used model for calculating the cost of equity is the **Capital Asset Pricing Model (CAPM)**:

![How the three CAPM inputs combine to produce the cost of equity: risk-free rate plus beta-adjusted equity risk premium.](data:image/svg+xml,%3Csvg%20xmlns%3D%22http%3A%2F%2Fwww.w3.org%2F2000%2Fsvg%22%20viewBox%3D%220%200%20660%20125%22%20width%3D%22660%22%20height%3D%22125%22%20role%3D%22img%22%3E%3Ctitle%3EFlow%20diagram%3C%2Ftitle%3E%3Crect%20width%3D%22100%25%22%20height%3D%22100%25%22%20fill%3D%22%23f8fafc%22%2F%3E%3Crect%20x%3D%2230%22%20y%3D%2225%22%20width%3D%22170%22%20height%3D%2275%22%20rx%3D%2210%22%20fill%3D%22white%22%20stroke%3D%22%232563eb%22%20stroke-width%3D%222%22%2F%3E%3Ctext%20x%3D%22115%22%20y%3D%2258.5%22%20text-anchor%3D%22middle%22%20font-family%3D%22system-ui%2C-apple-system%2Csans-serif%22%20font-size%3D%2214%22%20font-weight%3D%22600%22%20fill%3D%22%230f172a%22%3ERisk-Free%20Rate%3C%2Ftext%3E%3Ctext%20x%3D%22115%22%20y%3D%2278.5%22%20text-anchor%3D%22middle%22%20font-family%3D%22system-ui%2C-apple-system%2Csans-serif%22%20font-size%3D%2211%22%20fill%3D%22%2364748b%22%3ERf%20%3D%204.5%25%3C%2Ftext%3E%3Cline%20x1%3D%22205%22%20y1%3D%2262.5%22%20x2%3D%22237%22%20y2%3D%2262.5%22%20stroke%3D%22%2364748b%22%20stroke-width%3D%222%22%2F%3E%3Cpolygon%20points%3D%22244%2C62.5%20235%2C57.5%20235%2C67.5%22%20fill%3D%22%2364748b%22%2F%3E%3Crect%20x%3D%22245%22%20y%3D%2225%22%20width%3D%22170%22%20height%3D%2275%22%20rx%3D%2210%22%20fill%3D%22white%22%20stroke%3D%22%232563eb%22%20stroke-width%3D%222%22%2F%3E%3Ctext%20x%3D%22330%22%20y%3D%2258.5%22%20text-anchor%3D%22middle%22%20font-family%3D%22system-ui%2C-apple-system%2Csans-serif%22%20font-size%3D%2214%22%20font-weight%3D%22600%22%20fill%3D%22%230f172a%22%3EBeta%20%C3%97%20ERP%3C%2Ftext%3E%3Ctext%20x%3D%22330%22%20y%3D%2278.5%22%20text-anchor%3D%22middle%22%20font-family%3D%22system-ui%2C-apple-system%2Csans-serif%22%20font-size%3D%2211%22%20fill%3D%22%2364748b%22%3E1.2%20%C3%97%205.5%25%20%3D%206.6%25%3C%2Ftext%3E%3Cline%20x1%3D%22420%22%20y1%3D%2262.5%22%20x2%3D%22452%22%20y2%3D%2262.5%22%20stroke%3D%22%2364748b%22%20stroke-width%3D%222%22%2F%3E%3Cpolygon%20points%3D%22459%2C62.5%20450%2C57.5%20450%2C67.5%22%20fill%3D%22%2364748b%22%2F%3E%3Crect%20x%3D%22460%22%20y%3D%2225%22%20width%3D%22170%22%20height%3D%2275%22%20rx%3D%2210%22%20fill%3D%22white%22%20stroke%3D%22%232563eb%22%20stroke-width%3D%222%22%2F%3E%3Ctext%20x%3D%22545%22%20y%3D%2258.5%22%20text-anchor%3D%22middle%22%20font-family%3D%22system-ui%2C-apple-system%2Csans-serif%22%20font-size%3D%2214%22%20font-weight%3D%22600%22%20fill%3D%22%230f172a%22%3ECost%20of%20Equity%3C%2Ftext%3E%3Ctext%20x%3D%22545%22%20y%3D%2278.5%22%20text-anchor%3D%22middle%22%20font-family%3D%22system-ui%2C-apple-system%2Csans-serif%22%20font-size%3D%2211%22%20fill%3D%22%2364748b%22%3EKe%20%3D%2011.1%25%3C%2Ftext%3E%3C%2Fsvg%3E)

*How the three CAPM inputs combine to produce the cost of equity: risk-free rate plus beta-adjusted equity risk premium.*

**Cost of Equity (Ke) = Rf + β × (Rm − Rf)**

Where:
- **Rf** = Risk-free rate (typically the yield on 10-year US Treasury bonds)
- **β** (Beta) = The stock's sensitivity to market movements (systematic risk)
- **Rm** = Expected return on the overall market
- **(Rm − Rf)** = Equity risk premium (ERP), the additional return demanded over the risk-free rate

**Example calculation**:
- Risk-free rate (Rf): 4.5% (10-year Treasury yield)
- Beta (β): 1.2 (stock moves 1.2× as much as the market)
- Equity Risk Premium (ERP): 5.5%
- Cost of Equity = 4.5% + 1.2 × 5.5% = 4.5% + 6.6% = **11.1%**

## Understanding Each CAPM Component

**Risk-free rate (Rf)**: The yield on a risk-free asset. Practically, the 10-year US Treasury yield is used for US-denominated cash flows. As of 2024–2026, this has ranged from approximately 4.0–5.0%, significantly higher than the near-zero rates of 2010–2021. Higher risk-free rates increase the cost of equity, which reduces DCF valuations.

**Beta (β)**: Measures systematic risk, how much the stock moves relative to a market index. A beta of 1.0 means the stock moves in line with the market. A beta of 1.5 means 50% more volatile. A beta of 0.5 means half the market volatility.
- Utility stocks: β ≈ 0.3–0.7 (defensive, low-volatility)
- Consumer staples: β ≈ 0.5–0.8
- S&P 500 index: β = 1.0 by definition
- Technology stocks: β ≈ 1.2–1.8
- Small-cap growth stocks: β ≈ 1.5–2.5+

**Equity Risk Premium (ERP)**: The expected return of equities above the risk-free rate. Historical US ERP has averaged approximately 4–6% annually over long periods. Current implied ERP (based on market pricing and earnings forecasts) fluctuates; many practitioners use 5–6% as the long-run estimate.

## CAPM Component Summary

| Component | Typical Range | Source |
|---|---|---|
| Risk-free rate | 4–5% (2024–2026) | Current 10-year Treasury yield |
| Beta | 0.3–2.5 (most stocks) | Bloomberg, Damodaran database |
| Equity risk premium | 4.5–6% | Damodaran ERP estimates, historical |
| Resulting Ke | 6–18% for most stocks | Calculated |

## Alternative Models for Cost of Equity

**Dividend Discount Model (DDM)**:
For dividend-paying stocks, the cost of equity can be estimated from the current dividend yield and expected growth rate:

![Three approaches to estimating cost of equity, from the standard CAPM to multi-factor and dividend-based alternatives.](data:image/svg+xml,%3Csvg%20xmlns%3D%22http%3A%2F%2Fwww.w3.org%2F2000%2Fsvg%22%20viewBox%3D%220%200%20600%20211%22%20width%3D%22600%22%20height%3D%22211%22%20role%3D%22img%22%3E%3Ctitle%3EHierarchy%3C%2Ftitle%3E%3Crect%20width%3D%22100%25%22%20height%3D%22100%25%22%20fill%3D%22%23f8fafc%22%2F%3E%3Crect%20x%3D%22220%22%20y%3D%2220%22%20width%3D%22160%22%20height%3D%2258%22%20rx%3D%228%22%20fill%3D%22%232563eb%22%2F%3E%3Ctext%20x%3D%22300%22%20y%3D%2254%22%20text-anchor%3D%22middle%22%20font-family%3D%22system-ui%2C-apple-system%2Csans-serif%22%20font-size%3D%2214%22%20font-weight%3D%22700%22%20fill%3D%22white%22%3ECost%20of%20Equity%3C%2Ftext%3E%3Cpath%20d%3D%22M%20300%2078%20L%20300%20105.5%20L%20120%20105.5%20L%20120%20133%22%20stroke%3D%22%23cbd5e1%22%20stroke-width%3D%222%22%20fill%3D%22none%22%2F%3E%3Crect%20x%3D%2240%22%20y%3D%22133%22%20width%3D%22160%22%20height%3D%2258%22%20rx%3D%228%22%20fill%3D%22white%22%20stroke%3D%22%230891b2%22%20stroke-width%3D%222%22%2F%3E%3Ctext%20x%3D%22120%22%20y%3D%22158%22%20text-anchor%3D%22middle%22%20font-family%3D%22system-ui%2C-apple-system%2Csans-serif%22%20font-size%3D%2213%22%20font-weight%3D%22600%22%20fill%3D%22%230f172a%22%3ECAPM%3C%2Ftext%3E%3Ctext%20x%3D%22120%22%20y%3D%22176%22%20text-anchor%3D%22middle%22%20font-family%3D%22system-ui%2C-apple-system%2Csans-serif%22%20font-size%3D%2210%22%20fill%3D%22%2364748b%22%3ERf%20%2B%20%CE%B2%20%C3%97%20ERP%3C%2Ftext%3E%3Cpath%20d%3D%22M%20300%2078%20L%20300%20105.5%20L%20300%20105.5%20L%20300%20133%22%20stroke%3D%22%23cbd5e1%22%20stroke-width%3D%222%22%20fill%3D%22none%22%2F%3E%3Crect%20x%3D%22220%22%20y%3D%22133%22%20width%3D%22160%22%20height%3D%2258%22%20rx%3D%228%22%20fill%3D%22white%22%20stroke%3D%22%230891b2%22%20stroke-width%3D%222%22%2F%3E%3Ctext%20x%3D%22300%22%20y%3D%22158%22%20text-anchor%3D%22middle%22%20font-family%3D%22system-ui%2C-apple-system%2Csans-serif%22%20font-size%3D%2213%22%20font-weight%3D%22600%22%20fill%3D%22%230f172a%22%3EDDM%3C%2Ftext%3E%3Ctext%20x%3D%22300%22%20y%3D%22176%22%20text-anchor%3D%22middle%22%20font-family%3D%22system-ui%2C-apple-system%2Csans-serif%22%20font-size%3D%2210%22%20fill%3D%22%2364748b%22%3ED1%2FP0%20%2B%20g%3C%2Ftext%3E%3Cpath%20d%3D%22M%20300%2078%20L%20300%20105.5%20L%20480%20105.5%20L%20480%20133%22%20stroke%3D%22%23cbd5e1%22%20stroke-width%3D%222%22%20fill%3D%22none%22%2F%3E%3Crect%20x%3D%22400%22%20y%3D%22133%22%20width%3D%22160%22%20height%3D%2258%22%20rx%3D%228%22%20fill%3D%22white%22%20stroke%3D%22%230891b2%22%20stroke-width%3D%222%22%2F%3E%3Ctext%20x%3D%22480%22%20y%3D%22158%22%20text-anchor%3D%22middle%22%20font-family%3D%22system-ui%2C-apple-system%2Csans-serif%22%20font-size%3D%2213%22%20font-weight%3D%22600%22%20fill%3D%22%230f172a%22%3EFama-French%3C%2Ftext%3E%3Ctext%20x%3D%22480%22%20y%3D%22176%22%20text-anchor%3D%22middle%22%20font-family%3D%22system-ui%2C-apple-system%2Csans-serif%22%20font-size%3D%2210%22%20fill%3D%22%2364748b%22%3E3-factor%20model%3C%2Ftext%3E%3C%2Fsvg%3E)

*Three approaches to estimating cost of equity, from the standard CAPM to multi-factor and dividend-based alternatives.*

**Ke = (D1 / P0) + g**

Where D1 = next year's expected dividend, P0 = current stock price, g = sustainable dividend growth rate.

**Example**: A stock trading at $50, expected to pay a $2 dividend next year, with 5% annual dividend growth:
Ke = ($2 / $50) + 5% = 4% + 5% = **9%**

The DDM is simpler but only reliable for stable dividend-paying companies. It breaks down for growth companies that pay no dividends.

**Fama-French Three-Factor Model**:
A more sophisticated extension of CAPM that adds size (small-cap vs. large-cap) and value (book-to-market ratio) factors to the market beta:

**Ke = Rf + β_market × ERP + β_size × SMB + β_value × HML**

Used by academic researchers and sophisticated practitioners, particularly for portfolios. More complex but has empirically better explanatory power than single-factor CAPM.

## How Cost of Equity Differs from Cost of Debt

| Feature | Cost of Debt (Kd) | Cost of Equity (Ke) |
|---|---|---|
| Nature | Contractual interest rate | Implied required return |
| Tax treatment | Interest is tax-deductible | Dividends are not deductible |
| After-tax cost | Kd × (1 − tax rate) | No tax shield |
| Seniority in liquidation | Senior to equity | Residual claim, higher risk |
| Typical magnitude | 4–8% for investment grade | 8–15% for most equities |

![Cost of equity is consistently higher than cost of debt for the same company because equity holders bear more risk.](data:image/svg+xml,%3Csvg%20xmlns%3D%22http%3A%2F%2Fwww.w3.org%2F2000%2Fsvg%22%20viewBox%3D%220%200%20800%20210%22%20width%3D%22800%22%20height%3D%22210%22%20role%3D%22img%22%3E%3Ctitle%3EComparison%3C%2Ftitle%3E%3Crect%20width%3D%22100%25%22%20height%3D%22100%25%22%20fill%3D%22%23f8fafc%22%2F%3E%3Ctext%20x%3D%22230%22%20y%3D%2257.5%22%20text-anchor%3D%22end%22%20font-family%3D%22system-ui%2C-apple-system%2Csans-serif%22%20font-size%3D%2214%22%20font-weight%3D%22600%22%20fill%3D%22%230f172a%22%3ECost%20of%20Debt%3C%2Ftext%3E%3Crect%20x%3D%22240%22%20y%3D%2225%22%20width%3D%22234.78260869565216%22%20height%3D%2255%22%20rx%3D%226%22%20fill%3D%22%232563eb%22%2F%3E%3Ctext%20x%3D%22486.78260869565213%22%20y%3D%2257.5%22%20font-family%3D%22system-ui%2C-apple-system%2Csans-serif%22%20font-size%3D%2214%22%20font-weight%3D%22700%22%20fill%3D%22%232563eb%22%3E%256%3C%2Ftext%3E%3Ctext%20x%3D%22230%22%20y%3D%22152.5%22%20text-anchor%3D%22end%22%20font-family%3D%22system-ui%2C-apple-system%2Csans-serif%22%20font-size%3D%2214%22%20font-weight%3D%22600%22%20fill%3D%22%230f172a%22%3ECost%20of%20Equity%3C%2Ftext%3E%3Crect%20x%3D%22240%22%20y%3D%22120%22%20width%3D%22450%22%20height%3D%2255%22%20rx%3D%226%22%20fill%3D%22%237c3aed%22%2F%3E%3Ctext%20x%3D%22702%22%20y%3D%22152.5%22%20font-family%3D%22system-ui%2C-apple-system%2Csans-serif%22%20font-size%3D%2214%22%20font-weight%3D%22700%22%20fill%3D%22%237c3aed%22%3E%2512%3C%2Ftext%3E%3C%2Fsvg%3E)

*Cost of equity is consistently higher than cost of debt for the same company because equity holders bear more risk.*

Because equity is riskier (subordinate to debt, no guaranteed payment), the cost of equity is always higher than the cost of debt for the same company.

## Cost of Equity in WACC

The cost of equity is blended with the after-tax cost of debt (weighted by their proportions in the capital structure) to produce WACC:

**WACC = Ke × (E/V) + Kd × (1 − t) × (D/V)**

Where E = equity market value, D = debt market value, V = E + D, t = tax rate.

A company with 60% equity, 40% debt, Ke = 10%, Kd = 5%, tax rate = 25%:
WACC = 10% × 0.60 + 5% × 0.75 × 0.40 = 6.0% + 1.5% = **7.5%**

## Authoritative Sources

For deeper background and primary-source data on this topic, the following authoritative sources are useful starting points:

- [IRS](https://www.irs.gov/)
- [SEC](https://www.sec.gov/)

## Conclusion

The cost of equity is the implicit [hurdle rate](/blog/hurdle-rate) equity investors require, derived through CAPM by combining the risk-free rate, the stock's beta, and the equity risk premium. It is not a direct cash cost but represents the economic cost of using shareholders' capital. In DCF valuation and capital allocation, it is the minimum return threshold: any investment generating returns below the cost of equity destroys shareholder value, even if it is nominally profitable. For related capital structure concepts, see our guides on [WACC formula](/blog/wacc-formula) and [return on equity](/blog/return-on-equity).

Warren at [heywarren.com](https://heywarren.com) helps investors, analysts, and finance professionals build DCF models, understand capital structure, and apply cost of capital concepts to real-world valuation decisions.

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## Related Reading

**More from Warren**:
- [WACC: Formula, Components, and How to Calculate It](/blog/wacc-formula)
- [Return on Equity: What It Is and How to Calculate ROE](/blog/return-on-equity)
- [EBITDA to EV: What the Multiple Measures and How to Use It](/blog/ebitda-to-ev)

**Authoritative sources**:
- [Damodaran, Cost of Equity Data](https://pages.stern.nyu.edu/~adamodar/)
- [CFA Institute, CAPM and Cost of Capital](https://www.cfainstitute.org/en/membership/professional-development/refresher-readings/cost-capital-applying-principles-practice)
- [Federal Reserve, Treasury Yields](https://www.federalreserve.gov/releases/h15/)