Definition of cost of equity

The cost of equity is the rate of return required by the company's ordinary shareholders in order for that investor to bear the risk of holding that company's shares. The return consists both of dividend and capital gains. The returns are expected future returns, not historical returns.

There are two formulae commonly used to determine cost of equity. The first is the dividend growth model, which is (next year's forecast annual dividend divided by the current stock price) + the anticipated dividend growth rate.

The other formula is the capital asset pricing model, a more complicated formula which includes risk assumptions.

In October 2013, an FT writer was considering valuation metrics for Twitter's planned IPO. On aggressive ad sales projections, he wrote, a cost of equity of 22 per cent has to be built-in to reach a valuation of $15bn, the top of the range of estimates for Twitter.