In financial theory, the return that stockholders require for a company. The traditional formula for cost of equity (COE) is the dividend capitalization model:
A firm's cost of equity represents the compensation that the market demands in exchange for owning the asset and bearing the risk of ownership.
he capital asset pricing model (CAPM) is another method used to determine cost of equity.
CAPM
A model that describes the relationship between risk and expected return and that is used in the pricing of risky securities.
The general idea behind CAPM is that investors need to be compensated in two ways: time value of money and risk. The time value of money is represented by the risk-free (rf) rate in the formula and compensates the investors for placing money in any investment over a period of time. The other half of the formula represents risk and calculates the amount of compensation the investor needs for taking on additional risk. This is calculated by taking a risk measure (beta) that compares the returns of the asset to the market over a period of time and to the market premium (Rm-rf).
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