Definition
The term cost of common stock refers to a calculation that allows the investor-analyst to understand how expensive it is for a company to issue common stock. The cost of common stock is also one of three metrics used to calculate a company's cost of capital
Calculation
Cost of Common Stock = Risk Free Return + (Beta x (Market Return - Risk Free Return)
Where:
The risk free return is the theoretical rate of return for an investment that is risk-free. That is to say, the return is guaranteed. In practice the return on a government bond is typically chosen, such as US Treasury coupon bonds.
The beta for the stock indicates its volatility relative to the entire stock market. When beta is calculated for common stocks, it is typically with reference to a broad measure of stock performance such as the S&P 500.
The market return is the average market return for broad measure of stock performance. This would be the same metric used when calculating the stock's beta such as the S&P 500.
Explanation
Market performance measures allow the investor-analyst to understand the company's ability to achieve their high level business profitability objectives. This is usually assessed by examining metrics such as insider transactions, capture ratios, enterprise value, capitalization rates and price to earnings ratios. Market performance metrics provide analysts with a way to determine if a company is going to successfully execute their business plan. One of the ways to determine how expensive it is to provide a return to holders of common stock is by calculating the cost of common stock.
While the investor-analyst may be interested in a company's cost to provide holders of common stock with a return on their investment, the cost of common stock is also one of three components used when calculating a company's cost of capital. This later measure is important to understand since new investment decisions should produce results that generate returns greater than the company's cost of capital. The cost of common stock is calculated by taking the return on a risk free investment (such as a government bond) and adding to it the average return on the entire stock market minus the risk free return and then multiplying this value times to beta for the common stock. Multiplying this value by 100 allows the analyst to express the number as a percentage.
Example
The CFO of Company ABC is concerned the return on new investments are not being challenged and may be lower than the company's cost of capital. Much to her surprise, the company hadn't even calculated its cost of capital in recent years. After calculating the company's cost of debt (3.15%), and cost of preferred stock (2.90%), she asked her analytical team to begin the process of calculating the company's cost of common stock. The team pulled information from the company's balance sheet (common stock will be found as part of capital stock, which is reported in the stockholders' equity section of the balance sheet). They also calculated Company ABC's beta relative to the S&P 500. Finally, they used the US Treasury securities as their proxy for a risk free rate of return. The information below is what they found:
The average return on the S&P 500 was 10.45% over the last twenty years
Company ABC's beta was found to be 1.13
The return on US Treasury securities is currently 1.25%
From this information, the cost of common stock was calculated as:
= 1.25% + (1.13 x (10.45% - 1.25%)= 1.25% + (1.13 x 9.2%)= 1.25% + 10.40%, or 11.65%
The team has now found the cost of debt to be 3.15% the cost of preferred stock to be 2.90%, and the cost of common stock to be 11.65%. At this point, the team has all three factors needed to determine the company's cost of capital.
