Cost of Equity and Return on Equity

Definition of ‘Cost Of Equity’

In financial theory, the return that stockholders require for a company. The traditional formula for cost of equity (COE) is the dividend capitalization model:

Cost Of Equity

A firm’s cost of equity represents the compensation that the market demands in exchange for owning the asset and bearing the risk of ownership.

Investopedia explains ‘Cost Of Equity’

Let’s look at a very simple example: let’s say you require a rate of return of 10% on an investment in TSJ Sports. The stock is currently trading at $10 and will pay a dividend of $0.30. Through a combination of dividends and share appreciation you require a $1.00 return on your $10.00 investment. Therefore the stock will have to appreciate by $0.70, which, combined with the $0.30 from dividends, gives you your 10% cost of equity.

The capital asset pricing model (CAPM) is another method used to determine cost of equity.

 

Definition of ‘Return On Equity – ROE’

The amount of net income returned as a percentage of shareholders equity. Return on equity measures a corporation’s profitability by revealing how much profit a company generates with the money shareholders have invested.

ROE is expressed as a percentage and calculated as:

Return on Equity = Net Income/Shareholder’s Equity

Net income is for the full fiscal year (before dividends paid to common stock holders but after dividends to preferred stock.) Shareholder’s equity does not include preferred shares.

Also known as “return on net worth” (RONW).

Investopedia explains ‘Return On Equity – ROE’

The ROE is useful for comparing the profitability of a company to that of other firms in the same industry.

There are several variations on the formula that investors may use:

1. Investors wishing to see the return on common equity may modify the formula above by subtracting preferred dividends from net income and subtracting preferred equity from shareholders’ equity, giving the following: return on common equity (ROCE) = net income – preferred dividends / common equity.

2. Return on equity may also be calculated by dividing net income byaverage shareholders’ equity. Average shareholders’ equity is calculated by adding the shareholders’ equity at the beginning of a period to the shareholders’ equity at period’s end and dividing the result by two.

3. Investors may also calculate the change in ROE for a period by first using the shareholders’ equity figure from the beginning of a period as a denominator to determine the beginning ROE. Then, the end-of-period shareholders’ equity can be used as the denominator to determine the ending ROE. Calculating both beginning and ending ROEs allows an investor to determine the change in profitability over the period.

Things to Remember
  • If new shares are issued then use the weighted average of the number of shares throughout the year.
  • For high growth companies you should expect a higher ROE.
  • Averaging ROE over the past 5 to 10 years can give you a better idea of the historical growth.
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