Back to Valuation questions
How do you calculate the cost of stock (cost of equity) from P/E?
Answer
Cost of equity ≈ 1 / P/E (the earnings yield). A company with a P/E of 20x has an earnings yield of 5%, which is its implied cost of equity. This is a quick approximation used in accretion/dilution analyses for stock deals.
Why interviewers ask this
This is the M&A banker's shortcut: 'pay with stock at a yield, buy earnings at a yield.' If acquirer P/E > target P/E, the deal is accretive because the buyer's stock has a lower cost than the target's earnings yield.
cost of equityP/E