Explainer: Understanding Cost of Equity and Return on Equity

When investing, especially in stock, it is important and necessary to understand the meaning, use and implication of cost of equity and return on equity. Some use them interchangeably, but they are not the same thing.

What do they mean?

The cost of equity also known as the required rate of return is the rate of return an investor would require when investing in shares of a company.

Return on equity represents the return on equity that the owners of a company would have obtained if they would not have borrowed. It measures from the shareholders’ point of view a company’s efficiency at generating profits from its net assets i.e. equity deployed.

How do you calculate them?

Cost of equity is calculated using the dividend capitalization model or capital asset pricing model (CAPM). To calculate the cost of equity, find out if the company is paying dividends, if dividend is paid, you can use the dividend capitalization model, otherwise, use the capital asset pricing model. Using CAPM is tougher because you need to find out the beta by doing regression analysis, but you get it from finance websites. Calculating the cost of equity using the dividend model, divide the next year’s dividend per share (DPS) by the current market value and add this number to the growth rate of dividends D1 ÷ CMV +GR, where GR (growth rate = 1 – pay-out ratio). For CAPM, it is gotten using Rf + β(Rm-Rf), where Rf = risk-free rate, β = beta, and RM = expected market return.

Return on equity, primarily, is obtained by comparing net profit after tax with the total equity of the company i.e. net income divided by total equity. If a company has issued preferred stock or many classes of equity, when computing ROE, only the common stock is taken into consideration instead of the total equity.

Uses and Implications

Using zero, constant and/or multiple growth model (Dividend and EPS), the cost of equity can be used to determine current share prices (to know if the stock is overvalued or undervalued by the market) and thus helps forecast market expectations in terms of growth rate. Though the cost of equity is an important yardstick for an investor to consider before investing in a company or not, it should not be sacrosanct. It is better to look at the weighted average cost of capital that would give a holistic picture as the cost of debt also affects the dividend payment for shareholders.

Return on equity and return on assets are the two components of Return on Investment (ROI). ROA and ROE from the institutional investors’ points of view are two of the most important tools and they help to evaluate the performance of the individual enterprise on a comparable basis. Return on equity is very useful but for it to be effective, investors need to find out the reasons or ‘why’ behind the current ROE (high or low). For instance, not all high-ROE companies make good investments. Some industries have high ROE because they require no assets, while other industries require a large infrastructure before they generate profit. So, ROE can best be used for companies in the same industry. For instance, you can use ROE to compare the performance of Access bank with Zenith bank. Even when valuing companies in the same industry, the ROE component ratios (Asset Turnover, Net margin and Equity multiplier) have to be put together and interpreted as a whole in order to actually ascertain the overall position and performance of the company. A popular tool normally used in doing that is the “DuPont Analysis.” The DuPont Analysis looks at these three separate ratios, with the objective to show the effects of these ratios on the company’s return on equity. For illustration, assuming these two banks’ 2021FY ratios were:

Looking at the ROE of the two banks, Zenith Bank is more profitable overall, returning 20k for every Naira of shareholders’ investment, while Access Bank could only return 13k for every Naira invested. Also, Zenith Bank was able to record superior profitability than Access Bank because of its far better profit margin (36% vs. 16%) and Asset Turnover (0.082 times vs. 0.076 times). Therefore, Zenith bank was able to generate more profit for every N1 of sales and was more efficient in utilizing its assets to generate profit. But the gap in ROE of the two banks narrowed because Access bank had a higher equity multiplier (10.75 times) to that of Zenith bank (6.86 times).

Notwithstanding, it is important to find out the inherent reasons behind these ratios so as to make informed decisions. For instance, asset turnover may decrease due to investment in assets and the company may not necessarily generate enough sales from its assets. The leverage factor (Equity multiplier); which is a measure of the gearing of a firm may increase due to injection of more debt capital in its capital structure, may be towards the end of the financial year.

Holding every other thing constant, if ROE is higher due to increase in leverage (debt) then it is not good. Because lenders have an entitlement to interest of a fixed amount, irrespective of the level of profit, in the event of any fluctuation, in trading profit the shareholders of the company who are entitled to the residue of profit after interest has been paid will find that residue of profit fluctuate by a greater proportion than the fluctuation in trading profit. This effect can be measured using the ‘degree of capital gearing’ computed as profit before interest divided by profit after interest. The proportion by which the trading profit fluctuates, multiplied by the degree of capital gearing, and gives the proportion by which profit attributable to equity holders will fluctuate. Therefore, if the ROE increases as a result of increase in leverage, the company’s ROE will be subjected to more violent fluctuations.

Apart from using ROE as a profitability ratio, it can also be used to estimate sustainable growth rates and dividend growth rates, which is equally used to determine if a stock is overvalued or undervalued. To get the sustainable growth rates, just multiply the company’s ROE by the retention ratio. And to get retention ratio is 1 minus pay-out ratio. The sustainable growth rate is the rate a company can grow without having to borrow money to finance the growth.

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