Cost of equity (K_e) is the return required by equity investors. It is a valuation input - not a statement about where a stock is headed.
Saudi models often understate K_e when analysts rely on a mechanically low beta, or when they ignore the liquidity conditions that apply to smaller and less-traded names.
Start with CAPM
K_e = R_f + (β × ERP)
Document each input:
- SAR-consistent R_f (source and tenor)
- Beta method and stability test results
- ERP construction, including any country risk logic
- Any country risk component and where it sits (to avoid double counting)
Dividend Pricing Cross-Check for Mature Dividend Payers
For companies with a stable, mature dividend policy, a useful reasonableness check is:
K_e ≈ (D₁ / P₀) + g
Where D₁ is the expected next dividend, P₀ is the current price, and g is a conservative long-run growth rate.
This is a pricing cross-check, not a replacement for CAPM. If CAPM and the dividend check diverge materially, explain the drivers - differences in beta stability, ERP assumptions, or growth expectations. Avoid framing divergence as a claim about mispricing.
Liquidity Premium as a Sensitivity
For thinly traded names - especially small caps on Nomu or companies with limited float - CAPM may not fully capture liquidity risk. You can model a liquidity premium (LP) as an explicit sensitivity:
K_e(adjusted) = K_e + LP
Use an illustrative range such as 0.5%–3.0%, show sensitivity across that range, and document the rationale. Present it as a sensitivity, not a precise computed fact.
Illustrative Example
| Input | Value |
|---|---|
| R_f (SAR, 10-year) | 5.5% |
| ERP | 6.5% |
| Beta | 1.1 |
| K_e (CAPM) | 5.5% + (1.1 × 6.5%) = 12.65% |
| Liquidity premium (illustrative) | 1.0% |
| K_e (adjusted) | 13.65% |
Always Show Sensitivity
Present K_e and the resulting WACC across a sensitivity range. This reduces false precision and makes the model more useful for decision-making - which is the whole point.
This article is for educational purposes only. It explains valuation concepts and modeling choices. It is not investment advice, a recommendation, or a financial promotion. Examples use illustrative inputs. Verify all data using primary sources and consult an appropriately licensed professional before making financial decisions.
CFA® and Chartered Financial Analyst® are registered trademarks owned by CFA Institute. This content is not endorsed by or affiliated with CFA Institute.
Abdul Gaffar Mohammed, CFA
Treasury & Investment Professional