What Is the Connection between Return on Equity and Cost of Equity?
Profitability ratios determine a company’s return on profit, though they do not completely focus on profit margins. Two common attributes included in profitability analysis include the return on equity and cost of equity. Return on equity is a measurement that compares the company’s net income to the shareholders’ equity it takes to generate this income. The cost of equity represents how much a company must pay in order to generate the income, which is the external capital from shareholders. A connection exists between the two attributes, as a company cannot have one without the other.
The basic return on equity formula divides net income by the average shareholders’ equity from the company’s balance sheet. Average shareholders’ equity is simply the beginning shareholders’ equity plus ending shareholders’ equity divided by two. These two figures often come from a company’s year-end financial statements. Companies use the information to assess how efficiently they use invested funds. Higher returns are typically better as this means the company is good at earning financial returns.
Cost of equity is a bit different in terms of an overall calculation for a company. While the total cost may represent the amount of equity needed to fund a single project, the cost of shareholders’ equity is a dividend capitalization model. In terms of measuring profitability, the latter formula is dividends per share divided by the market value of stock plus the dividend growth rate. This formula includes the remuneration investors demand when risking their funds in a business. There are other models for measuring a company’s cost of equity, however.
A company often reviews its return on equity and cost of equity at various times during its operations. This real-time analysis ensures the company remains profitable through each major set of operations or projects. For example, a company paying copious dividends or experiencing a high dividend growth rate often has higher costs that it needs to cover with its net income, so it is possible for a company’s cost of equity to reduce its net income.
Investors can also calculate these numbers for a company. Information taken from publicly released financial statements contains the necessary information for this process. It helps investors in selecting the most profitable stocks in which to invest funds for potential financial returns.
Reminds me a lot of the traditional way to judge whether a trucking company is doing well or not -- the operating ratio. In short, a ratio below 1.0 is good, anything high is bad.
The ratio is a simply analysis of how much money it costs to generate $1 in revenue. An operating ratio of .90 simply means the company had to spend 90 cents for every dollar of revenue generated and is (on paper, at least) healthy.
An operating ratio higher than 1.0, on the other hand, means the company is not doing well at all and is losing money.
The point here is that a rough estimate of the profitability of any company often boils down to a single metric. Knowing which companies can be measured by which metrics can be tricky, but it can usually be done.
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