What is the Cost of Common Stock?

Common stock is a type of security/instrument issued to Equity shareholders of the Company. These are commonly known as equity shares in India. It is also called ‘Common equity 

Preference shares or preferred stock are shares of a company that has a right to receive a stipulated amount of dividend decided by the Company.  Equity shareholders are the owners of the Company and are eligible to share in the profits of the company, and also have voting rights. In the event of winding up of the Company, the common stock investors receive any remaining funds after all the stakeholders are paid, which means post the debt holders, bondholders, creditors (including employees), and preferred stockholders are paid. 

The term "common stock" is used as the holder of stock doesn’t own any asset in particular but owns a part of everything, hence the word Common Stock. 

Both equity and preferred stock together are considered while calculating a company’s market capitalization. 

Cost of Common Stock 

The return expected by common stockholders of the Company is called Cost of Common stock, it is also called Cost of Retained earnings or Return on Retained Earnings or Par value of a stock. 

The connotation used to describe Return on retained earnings or cost of common stock is r_e. 

The Cost of common stock is difficult to calculate as compared to the cost of debt and cost of preferred stock, Debt holders and preferred stockholders are paid dividend/interest at a predetermined rate. Thus, the debt holder or preferred stockholder already knows the Cost of their funds. 

Methods of Calculating Cost of Common Stock 

There are various methods for valuation of Common Stock and the same can be calculated using three methods described below  

1. Dividend Discount Model (DDM) or Discounted Cash Flows model (DCF) 
2. Capital Asset Pricing Model (CAPM) 
3. Bond yield plus risk premium or risk-adjusted premium approach. 

Dividend Discount Model 

This method assumes a stable growth in dividends year after year. 

Formula: 

$$r_e=\frac{D_1}{P_0}+g$$

D₁=Dividend that Company is expected to pay. 

P₀ = Current Market Price of the stock or present value of stock or stock price currently or NPV 

G = Dividend growth rate each year

Limitations of this Method 

This method assumes a constant growth rate in returns. A company having fluctuating growth rates may not be able to calculate the accurate rate of return. This method assumes that the Company pays a dividend or expects to pay a dividend. This method becomes obsolete if the Company doesn't pay a dividend at all.  

Assumes that the Company already knows the dividend or growth rate since the start. 

This method may be useful for Companies who have been there for a longer duration and know the dividend paid and its growth rate historically. This model may not be best for newer companies, which will have to assume the dividend and growth rate. Higher the assumptions, less precise and accurate the derived number.  

It does not consider market risks while calculating returns. 

Companies using this model 

This model is best suited for Companies that have seen some trend in dividend pay-outs. i.e., Companies who have historically paid dividends will know the dividends paid over the period and can estimate the expected dividend by using past trends. 

Example:  

A Company is expected to pay a dividend of $10 per share/stock held, Current market price of the stock is $100. The company expects the dividend to grow by 10%. What will be the Cost of common stock or the rate of retained earnings? 

$$r_e=\frac{\$10}{\$100}+10\%=20\%$$

The cost of retained earnings/equity share will be 20% as per DDM. 

Capital Asset Pricing Model Or CAPM

This method takes into consideration the market return for similar security and the market risk multiplier to arrive at the cost of common stock. 

The formula used to calculate the Cost of Common Stock under the CAPM method is: 

$$r_e=r_f+\beta \times \left(r_m-r_f\right)$$

Risk-Free Rate of return  

The risk-free rate of return is the return on the stocks that involves absolutely zero risks and you are guaranteed to at least get this rate of return over your securities. 

Instruments considered to be risk-free are Government securities or US Treasury securities. The returns provided by these securities can be considered as risk-free and used in the formula above for CAPM-based retained earnings (r_e) calculation. 

Expected Market Return  

Typically the average rate of return provided by similar securities belonging to the same industry is considered as the expected market return.  

Stock's Beta or Risk  

Stocks’ beta represents how risky the stock is compared to the market’s risk as a whole. Beta for the market as a whole is considered as 1.0. Depending on the riskiness of the stock for which return is being calculated, the Beta varies. 

Example: If the Market risk is 1.0, riskier security will fetch a higher Beta, say 10% higher than the stock’s beta will be 1.1. 

If the stock is comparatively risk-free compared to the market, it will have a beta lower than 1.0. 

Example: 

The rate of return provided by the Treasury bill is 6%. Stock is 10% riskier than the market. The market is providing a return of 12% for similar securities. What is the cost of common stock? 

$$r_e=6\%+1.1\times \left(12\%-6\%\right)=12.6\%$$

The cost of Common stock is 12.6%. 

Limitations of this Method 

It is very difficult to estimate the Market risk factor in reality and someone using the CAPM model should always remember that fluctuation in this may render the output useless. 

The method assumes that the stock acts like the market. The underlying stocks considered in the market risk calculation may not be exactly like the stock in question. 

For risk-free return, generally returns from Treasury securities are considered. These securities are short-term in nature and their yield changes daily. 

Companies that use this model 

This is a widely used model for determining the cost of common stock. Companies belonging to industries that can reasonably provide for market risk factors and market returns can use this model. 

Bond Yield Plus Risk Premium Approach 

A very crude method of calculating the Return on equity is the bond yield plus risk premium method. 

Formula:

$$r_e=Bond yield+Risk premium$$

Bond yield= Yield paid by the Company to its bondholders less tax rate. (Note-Yield should be after-tax, not before-tax.) Yield is also known as the after-tax cost of bonds. 

The same could also include long-term debt. 

Risk Premium= Difference between Bond yield and stock yield 

The main assumption in this method is we assume the cost of equity is always higher than the cost of debt within the same company. This is from the assumption that equity investments are always riskier than investments in debt instruments of the same company. 

Limitations of this method 

Assuming that the bond yield is always lower than the equity return may not always be true. 

Companies using this model

It is a very crude method of calculation, may not be very accurate. Hence not widely used. Mostly used by Companies fairly new in the market, wanting to value new common stock or new equity. 

Choosing the Right Method 

As we have already seen since there is no precise agreement between the equity holders and the Company, the Cost of common stock calculations involves a lot of difficulties. Hence there are multiple methods provided to arrive at a more accurate method. 

Depending on their suitability to the stock in question, the company should use the method. All the methods have some assumptions level involved. Understanding the Company, industry, and market factors are very important while choosing the method of calculation. The lower the assumptions, the more accurate output we get. Every assumption should have a logic behind why it was chosen. 

A company that has a history of paying dividends and has a more stable growth rate could use this DDM method. A company that can accurately predict the market risk and market return could use CAPM. While just for a rough calculation, the Bond yield method could be used. 

A Company can also calculate the weighted average cost of capital stock assuming equal weights to all the methods to arrive at a near to accurate cost. However, it is important to note that floatation cost is also to be considered but unfortunately is not given much importance. 

Common Mistakes 

1. Not choosing the right method. 
2. Not assuming correct risk factors. 
3. Not considering market risks, economic conditions, and past trends while calculating the returns. 
4. Not knowing the company or market factors. 

Context and Application 

This topic is applied in the courses below: 

• Bachelor of Commerce 
• Chartered Accountancy: Financial Management 
• CIMA (Management Accounting) 
• MBA 
• CFP 
• CFA 
• CPA