Damodaran on Valuation

2.2. COST OF EQUITY

The cost of equity is a key ingredient of every discounted cash flow model. It is difficult to estimate because it is an implicit cost and can vary widely across different investors in the same company. In this section, we begin by examining the intuitive basis for the cost of equity and we then look at different ways of estimating this cost of equity.

2.2.1. Intuitive Basis

As we noted in Chapter 1, the cost of equity is what investors in the equity in a business expect to make on their investment. This does give rise to two problems. The first is that, unlike the interest rate on debt, the cost is an implicit cost and cannot be directly observed. The second is that this expected rate need not be the same for all equity investors in the same company. Different investors may very well see different degrees of risk in the same investment and demand different rates of return, given their risk aversion. The challenge in valuation is therefore twofold. The first task is to make the implicit cost into an explicit cost by reading the minds of equity investors in an investment. The second and more daunting task is to then come up with a rate of return that these diverse investors will accept as the right cost of equity in valuing the company.

2.2.2. Estimation Approaches

There are three different ways in which we can estimate the cost of equity for a business. In the first, we derive models that measure the risk in an investment and convert this risk measure into ...