Thus,thecostofequityisthesumofthedividendyieldand
thelong-termexpectedgrowthrateindividends(orearnings).
Forastockwithadividendyieldof 3 percentandanexpected
growthrateof 4 percent,thecostofequityis 7 percent.The
computationwillgetmorecomplicated,thoughtheintuition
doesnotchange,aswemovefromdividendstocashflowsto
equity and from stable-growth models to high-growth models.
Thelimitationofthisapproachshouldbeobviousfromthe
exampleusedearlier.Ifweusetheimpliedcostofequityto
valueastock,wewillalwaysfindthestocktobecorrectly
valued. For this approach to have any practical use in
valuation,therefore,wehavetoconsidercreativevariations.
Oneistocomputetheimpliedcostofequityforeachfirmin
asectorandtoestimateanaverageacrossfirms;thisaverage
costofequitycanthenbeusedtovalueeverycompanyinthe
sector.Anotheristocomputetheimpliedcostofequityfor
thesamefirmover manyyears andusetheaverage across
time as the cost of equity today.
FROM COST OF EQUITY TO COST OF CAPITAL
Whileequityisundoubtedlyanimportantandindispensable
ingredientofthefinancingmixforeverybusiness,itisbut
one ingredient. Most businessesfinance some or much of
theiroperationsusingdebtorsomehybridofequityanddebt.
Thecosts ofthese sourcesof financing aregenerallyvery
differentfromthecostofequity,andthecostofcapitalfora
firmwillreflecttheircostsaswell,inproportiontotheiruse
in thefinancing mix. Intuitively,the cost ofcapital is the
weightedaverageofthecostsofthedifferentcomponentsof
financing—including debt, equity, and hybrid
securities—used by a firm to fund its financial requirements.