Cost of Equity and Rate of Return

Cost of Equity

The cost of common equity is represented as r_e, and it is the rate of return required by the common shareholders. It reflects the expected equilibrium total returns on the shares in the market.

The cost of common equity can be measured using the Capital Asset Pricing Model (CAPM) or the Dividend Discount Model. These models are discusses in detail in other readings.

Investor's Required Rate of Return

In the dividend discount model, an investor uses the expected rate of return (cost of equity) to discount the future cash flows from the stock and arrive at the intrinsic value of the stock. If expected rate of return increases, the intrinsic value will fall and vice versa. The investor can calculate the intrinsic value and then compare it with the market price of the stock to see if it's an attractive investment or not.

In general:

• If Intrinsic Value > Market Price, the stock is undervalued. The investor will want to buy the stock.

• If Intrinsic Value = Market Price, the stock is fairly valued. The investor is neutral about the stock price.

• If Intrinsic Value < Market Price, the stock is overvalued, and investor expects its price to fall.

Accounting Return on Equity

Return on equity is one of the most popular measures of financial performance. ROE measures accounting earnings for a period per dollar of shareholder's equity invested.

$ROE = \frac{\text{Net Income}}{\text{Average Book Value of Common Equity}}$

Sometimes, instead of taking average value of equity, the book value at the beginning of the year is used. Average book value is useful if book value is volatile. Beginning book value of equity can be used if book value is stable.

If the ROE of a company is increasing, it is a positive sign; however, the analyst must identify the reasons behind it. For example, raising more debt will reduce the overall book value of equity and show higher ROE. Raising more debt also makes the company's shares riskier.