A CEO's Most Important KPI: Cost of Equity (ke)

Running a company is a brutal job.

"It's a complex, demanding role that requires balancing short-term and long-term goals, strong leadership, strategic thinking, and the ability to make hard decisions under uncertainty." (based on ChatGPT) So here's a question for you, the person who took that job.

Why are you walking this road of nails?

Maybe you want to disrupt a market with an idea that's yours alone. Maybe you'd rather sign the paychecks than cash them, and build a career on your own terms. Or, more honestly, maybe you just want your own company and the respect that comes with the title.

There are countless answers to that question. But corporate finance gives you exactly one metric to settle it.

"You become CEO because you've decided you can earn at least the cost of equity (ke), the minimum return your shareholders require."

Cost of equity, ke

Let me ask you something. Why do people put their hard-earned money into a risky company instead of parking it safely in the bank?

Obviously, because they're willing to take that risk in exchange for a bigger return. It's the same logic that has retail investors studying the market to trade stocks and crypto.

A group that raises capital from all these sources and uses those assets to generate profit, that's exactly what a "company" is. The capital can come from creditors lending money as debt, or from VCs, retail investors, and the CEO putting in equity as shareholders.

Now here's the really important question.

So what standard do these people use to decide whether to invest?

A creditor is just lending money, so the relationship ends once they get principal and interest back on time. The minimum return they require, their bar for investing, is simply the interest rate.

But what about the shareholders, the actual owners of the company (including a founder-CEO)?

There's no safety net of interest and principal repayment anywhere. If the company goes under? The money evaporates. *The capital put in by the founder and other shareholders is also an "investment."

Still, as an owner of the company, is there really no minimum return you require when you invest?

NOPE!

Of course there is. Even you, as both CEO and shareholder, used some standard to make the call when you invested in your company.

In corporate finance, that benchmark, the "minimum required return" buried in the minds of all those varied and complicated shareholders, is defined as the cost of equity.

ke = risk-free rate + risk premium (equity market risk premium × β)

Let me walk through the ke formula simply.

Say you, as CEO, took ~$100K of your own money and, instead of investing it elsewhere, put it into the company as equity.

• If you had instead invested in a government bond, with a guaranteed 100% return and essentially zero risk, you'd obviously have earned at least the bond's interest, right? → the risk-free rate

But instead of that safe bond, you stepped into the risky arena of running a business. In that case, there are two things to think about.

1. What if, instead of running a business directly, you chose to invest indirectly by buying other companies' stocks through the equity market?

The compensation for that risk is the equity market risk premium, simply put, the return the average market return earns above the risk-free rate.

*equity market risk premium = (average market return − risk-free rate)

Of course, a smart investor wouldn't dump everything into a single company, no "all-in" bets, and would build a diversified portfolio instead. Corporate finance assumes exactly this kind of rational investor.

2. But in the end, what you chose was running the company yourself, the direct route!

When you run a company directly, the risk level of the industry your business operates in comes into play. This is the famous beta coefficient, β. Put simply, it's the risk factor specific to a given industry. It's a metric you can easily look up online.

• The compensation that accounts for both of the risks you've shouldered as CEO is none other than the risk premium. No reward, no reason to take the risk, right?
   →  risk premium (equity market risk premium  × β )

So the company's shareholder gives up the 100% guaranteed risk-free return and has to earn the equity market risk premium, adjusted for industry risk, as compensation for that risk. You started the business believing you could earn at least the sum of these two.

That's the reason, in corporate finance terms, that a shareholder decides to invest in their own company.

Why does cost of equity matter?

It's the most rational, unvarnished metric for proving your business is justified.

Once you're the CEO of a company, you have to make the most rational, strategic decisions, always.

If you're posting a return higher than your cost of equity, congratulations. You're running a wildly successful operation that's earning its risk premium and then some.

But what if your return comes in below your cost of equity?

Then there was no point in taking on the risk you took as the owner who invested in this company.

In the worst case, it's time to seriously ask whether you should keep running the business at all. Coldly speaking, rather than acting as a shareholder, you might be far better off investing in government bonds or going the indirect route through a fund (an equity portfolio).

We know all too well that being a CEO isn't a volunteer gig.

In the end, what a CEO has to pursue is to constantly check, manage, and improve whether you're earning the return you ought to be earning, your cost of equity.

That's how you keep finding, for yourself, the reason you took on this grueling job in the first place, and stay motivated. Right?