Dykstra: Determining the Cost of Equity

Now that you know how to determine the cost of a company's debt, learn how to calculate the cost of its equity.
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On Monday, the markets were pumped up by details of the administration's plans to restore the banking sector. The NYSE jumped 7.3%, and the Dow Jones Industrial Average gained 6.8% to close near 7,776. Those big gains were all we needed to score a couple of wins for my deep-in-the-money options trading system.


(CSCO) - Get Report

, which had been in play for 103 days, rang the bell, adding $3,900 to my win column.


(HPQ) - Get Report

also rounded home, winning $1,000 after just one week in play. These additions to my scorecard bring my record to 98-1. I'm getting closer than ever to an even 100 since


began distributing my Nails on the Numbers newsletter last spring.

My first win of $1,000 last year came April 2, on

Sigma Designs


on its third trading day out. And a successful closeout of my


(GRMN) - Get Report

position came the following day - the same day that I picked it.

Not quite in the win column yet,


(MSFT) - Get Report

, my March 13, 2009 pick, came within 5 cents of winning on Monday. Another up day in the stock will push it over the top.

Those wins are on top of this month's $1,000 win in

Cameron International


, bringing my total wins to date in March to $5,900.

Last week,

I covered how to determine a company's cost of debt

, which is one part of total capital. This week, I will look at how to calculate the cost of a firm's equity. When we combine them, we get the company's weighted average cost of capital. This number becomes useful when comparing it to return on capital -- to see if the company is using its assets to its best advantage.

In last week's example, we determined that


(HAL) - Get Report

total capital (debt plus equity) came to $18.8 billion at the end of 2008. Total capital was 13.8% long-term debt and 86.2% equity.

Now, let's determine the cost of equity. To get that, we'll use a formula called the capital asset pricing model. The math for the CAPM formula is fairly simple. Here's how you can get a working CAPM: Look up the current 3-month T-bill rate (0.0019 on Monday), known as the risk-free rate. Next, look up Halliburton's beta on


You'll find it


Beta measures a stock's risk and return compared to the overall market, with 1.0 being the market's risk and return. Halliburton's beta of 1.43 indicates it carries higher risk than the market.

We multiply its beta by a standard 6.7% -- the market's historical excess return rate. Then we add that to the risk-free rate of 0.0019, which gives us 0.0977, or 9.8%.

Here's the CAPM formula in plain English, with the market's historical excess return rate already plugged in: beta times 0.067 plus the 3-month T-bill rate = cost of equity.

A stock's beta can vary according to the methodology used by the data source, so these calculations are not hard and fast numbers. Still, they are useful guides.

Next time, we'll combine the weighted cost of equity with the weighted cost of debt for Halliburton's total cost of capital. Then we will compare that to the company's historical return on capital.

At the time of publication, Dykstra had no positions in stocks mentioned.

Nicknamed 'Nails' for his tough style of play, Lenny is a former Major League Baseball player for the 1986 World Champions, New York Mets and the 1993 National League Champions, Philadelphia Phillies. A three time All-Star as a ballplayer, Lenny now serves as president for several privately held businesses in Southern California. He is the founder of The Players Club; it has been his desire to give back to the sport that gave him early successes in life by teaching athletes how to invest and protect their incomes. He currently manages his own portfolio and writes an investment strategy column for TheStreet.com, and is featured regularly on CNBC and other cable news shows. Lenny was selected as OverTime Magazine's 2006-2007 "Entrepreneur of the Year."