Discount rates and the cost of equity

In simple terms

When you buy a share, you give up the chance to put the money somewhere safer. You accept the risk that the company's profits disappoint, that its share price falls, or that it fails. In return, you expect a higher return than a safe investment would give.

The cost of equity is that required return: the return shareholders need, given the risk, to be willing to own the shares. It is called a cost because, from the company's point of view, it is the price of shareholders' money. In valuation, it is the discount rate used to turn future cash flows to shareholders into a present value.

Building blocks

The risk-free rate. The return on an investment with as little risk as possible. Analysts usually use the yield on long-term government bonds in the same currency as the cash flows, because the government is very unlikely to fail to pay in its own currency. This rate changes over time with interest rates in the economy.

The equity risk premium. The extra return investors require for holding shares in general rather than government bonds. It cannot be observed directly. Analysts estimate it from long histories of share returns, from surveys, or from the returns implied by current share prices, and different methods give different answers.

A company-specific adjustment. Some companies are riskier than the market as a whole, some less so.

The capital asset pricing model

The most widely taught method is the capital asset pricing model (CAPM):

Beta measures how much a share's returns have moved with the market's. A beta of 1 means the share has tended to move in line with the market; above 1, more than the market; below 1, less. CAPM says investors only need compensating for this market-related risk, because other risks can be removed by diversifying.

Criticisms of CAPM

CAPM is simple and widely used, but its weaknesses are serious.

• Beta is unstable. It changes depending on the period and frequency of the data used, and past movements may not describe future risk.
• Beta measures only price movements, not business risks such as heavy debt, governance problems or a single large customer.
• The equity risk premium cannot be measured precisely, and small changes in it move the cost of equity a lot.
• Evidence is mixed on whether shares with higher betas actually earn higher returns over long periods.

Because of these problems, many practitioners treat CAPM as a starting point and adjust it, or use simpler approaches: a required return built from the bond yield plus a premium that reflects their own judgement of the company's risk.

Why reasonable people use different rates

Two careful analysts can choose different discount rates for the same company because they use different risk-free rates, different premiums or different judgements of risk. A difference of two percentage points is common, and it can change a valuation by a third or more.

The honest response is not to pretend to precision but to:

1. Choose a rate you can justify, in line with the risk of the business.
2. Test a range of rates, as the sensitivity analysis lesson shows.
3. Ask what return the current price implies, using a reverse DCF, and decide whether that return is enough for you.

Why it matters

The discount rate is one of the most influential inputs in any valuation. It turns a forecast of future cash into a price you should be willing to pay today. Understanding how it is built helps you see why share prices react to interest rates, why risky companies are valued at lower multiples, and why any single "fair value" hides a judgement about risk.

Limitations

The cost of equity is an estimate of investors' required return, not a fact. Every method relies on assumptions about the future drawn from the past. The examples here use made-up figures; actual risk-free rates and premiums change with market conditions and should be taken from current sources.

Common mistakes

• Treating the cost of equity as a precise, known number.
• Using a risk-free rate in a different currency from the cash flows.
• Relying on beta alone for a company with heavy debt or governance risks.
• Using one rate without testing others.

Try it yourself

1. Find the current yield on a long-term government bond on the Reserve Bank of India's website.
2. Choose an equity risk premium you can defend, and write down why.
3. For two listed companies, one steady and one cyclical, estimate a cost of equity using CAPM with betas from a financial website, and then using your own judgement of risk.
4. Note how far apart the estimates are.