The cost of equity is the amount of return that an investor desires to make from an investment in order to consider the transaction worth his or her time and effort. This return is usually achieved by a combination of dividends generated by the investment, as well as the upward movement in the value of the security during the time it is held by the investor. Should a given investment fail to perform according to expectations, the asset is normally sold and the investor seeks to acquire a security that will generate the desired rate of return.
Determining the potential cost of equity is a relatively straightforward process. First, the investor determines what rate of return over a specified period of time would make owning the security worthwhile. That return is usually expressed in terms of a percentage over the purchase price. By allowing for the amount of the projected dividends earned by the security within the time period, as well as allowing for the projected increase in the value of the investment, it is possible to determine if the return will be enough to meet the goals of the investor.
For example, if an investor requires a cost of equity of ten percent, that means the investor wants to achieve a ten percent overall return on that investment. If half of that percentage is earned through dividend payments and the other half is achieved through increases in the market value of the security, then the investor has received the desired rate of return. Should the dividend payments amount to half of the desired percentage, but the security only rises by a quarter of the cost of equity, then the investor does not achieve the desired return, and is likely to sell the security, assuming there are no indications that the market value will increase substantially within the short-term.
It is important to note that failure to achieve the desired cost of equity does not necessarily mean that an investment is not earning some rate of return. Rather, the rate of return is below the levels that must be met in order for the investor to consider the investment to be worth the cost of owing that security. From this perspective, the cost of equity is helpful in evaluating specific investments, based on past performance. If a particular investment does not show some promise of performing at a level that would allow the investor to receive the desired rate of return, then he or she can move on to the next opportunity, and determine if that investment is likely to earn a more desirable rate of return.
