Cost of Equity

The Capital Asset Pricing Model states: Ke = Rf + β × (Rm - Rf). The risk-free rate (Rf) is the yield on a 10-year U.S. Treasury bond (currently ~4.2–4.5%). Beta (β) measures the stock's volatility relative to the market — a beta of 1.2 means the stock moves 20% more than the market. The equity risk premium (Rm - Rf) is the excess return investors demand for holding stocks instead of risk-free bonds (typically 5.5–7.0% based on historical averages). This model assumes markets are efficient and investors are well-diversified.

Beta can be observed (regressing a stock's returns against market returns) or estimated using comparable company betas. For private companies or divisions, you use unlevered (asset) betas from public comps and then re-lever to the target capital structure: Levered Beta = Unlevered Beta × [1 + (1 - T) × (D/E)]. This ensures beta reflects the appropriate level of financial risk. Most databases (Bloomberg, FactSet) provide both raw and adjusted betas — adjusted betas are 'Bayesian' estimates that move toward 1.0 over time.

For small-cap companies, analysts add a size premium (1–3%) because smaller stocks historically earn higher returns due to less liquidity and higher volatility. For companies in emerging markets, a country risk premium (1–5%) is added to account for political, currency, and economic instability. The modified CAPM formula becomes: Ke = Rf + β × ERP + Size Premium + Country Risk Premium. These adjustments are essential for accurate valuations in international M&A.

While CAPM is dominant, alternatives exist. The Dividend Discount Model implies Ke = (D₁ / P₀) + g (next year's dividend yield plus growth rate). The Build-Up Method adds risk premiums for equity risk, size, industry, and company-specific factors. The Fama-French Three-Factor Model adds size (SMB) and value (HML) factors to CAPM. In practice, bankers use CAPM as the primary method and sanity-check with these alternatives. In interviews, CAPM is almost always what they're asking about.