Estimating the cost of equity for financial institutions

Abstract

This article estimates the cost of equity for a large sample of European financial institutions. To this end, two main approaches are considered: (i) a dividend discount model for a broad market index, combined with a single-factor framework to estimate the cost of equity for individual stocks; and (ii) a multi-factor time-series model combining stock and bond-market factors. It is found that, while the two approaches generally yield similar results, both in terms of their levels and their time series dynamics, discrepancies can be substantial. All in all, the dividend discount model is a less data-intensive approach that may be more effective to monitor the cost of equity in real time. In contrast, multifactor models are more data intensive and hence less convenient for regular monitoring. At the same time, though, this latter methodology is more useful to capture the impact of developments not captured by the broad market index, owing to its multi-factor structure.