H. Compare and contrast a company’s cost of equity, its (accounting) return on equity, and investors’ required rates of return Flashcards
SchweserNotes: Book 4 p.266 CFA Program Curriculum: Vol.5 p.181
The accounting return on equity (ROE) is calculated as the firm’s net income divided by the book value of common equity
ROE measures whether management is generating a return on common equity but is affected by the firm’s accounting methods.
When analyzing an industry characterized by increasing book values of equity, return on equity for a period is most appropriately calculated based on: Average Book Value
When book values are not stable, analysts should calculate ROE based on the average book value for the period. When book values are more stable, beginning book value is appropriate.
The ratio of the firm’s net income to its average book value is the firm’s return on equity, which can be greater than, equal to, or less than the firm’s cost of equity.
Which of the following changes would most likely cause a firm’s return on equity to increase? Net income decreases by 5% and average book value of equity decreases by 10%. Return on equity is net income divided by average book value of equity. If the book value of equity decreases relatively more than net income decreases, return on equity will increase. This illustrates that an increase in ROE is not necessarily positive for the firm. An analyst must examine the reasons for changes in ROE.
• ROE (Accounting ROE) is calculated as net income available to common
(net income minus preferred dividends) divided by the book value of
common equity
• ROE = (Net Income – preferred dividends) / BV of Equity
• Different calculations of accounting ROE
– Use of ending BV of equity
– Use of average BV of equity
• Use either measure but be sure to be consistent
• Higher ROE is generally viewed as positive, but the reason for increase
should be examined. If BV is decreasing more rapidly than net income,
ROE will increase. But this is not positive for the firm.
• The book value of equity reflects a firm’s financial decisions and operating
results since its inception
The firm’s cost of equity is the minimum rate of return that investors in the firm’s equity require
Investors’ required rates of return are reflected in the market prices of the firm’s shares.
Cost of equity for a firm can be defined as the expected equilibrium total return in the market on its equity shares, or as minimum rate of return that investors require as compensation for the risk of the firm’s equity securities. The market value of equity reflects the market’s consensus view of a
firm’s future performance
Price to Book Ratio
Price to book ratio is the market value of a firm’s equity, divided by its
book value. More optimistic investors are about the firm’s future
growth, the greater its price to book ratio.
– Low price‐to‐book ratios are considered value stocks
– High price to book ratios are considered growth stocks
• Company with better growth outlook than other firms in industry
have higher P / B multiple.
Raise capital efficiently to minimize its cost (cost due to earning
reduction or dilution)
Intrinsic Value
Intrinsic value ‐ the discounted value of the cash that can be taken
out of a business during its remaining life.
Cost of Debt
Cost of debt – easy to calculate by looking at interest rate.
Cost of equity (common)
Cost of equity (common) – more difficult to estimate as there are not
mandatory payments to equity investors.
Cost of equity – minimum expected rate of return investors require to
purchase shares in the secondary market.
• Companies, of course, try to raise capital at the lowest possible cost,
and the company’s cost of equity is often used as a proxy for the
investors’ minimum required rate of return.
• If the companies expected rate of return is not maintained in the
secondary market, then the share price will adjust so that it meets the
minimum required rate of return demanded by investors.