In the subject of finance, financial ratios are useful because they allow for comparison between different businesses. Investors and analysts use ratios to conclude whether one investment opportunity appears to be more attractive than another. Finance theory textbooks contain many ratios which measure financial performance, but these are two of the most widely used ratios in this category.
Definitions and meanings
Return on equity
Return on Equity (ROE) is a financial ratio that measures the financial return generated by a company, relative to the value of money invested as equity into the share capital of the business. This is different to return on capital employed, which compares profits to all assets employed by the company. The difference is that all assets may be financed by a combination of debt and equity. Whereas the return on equity only measures equity investments. In layman’s terms, return on equity can be understood as the rate of return that you would enjoy as the sole owner of a business. Return on equity is generally given as the following:
ROE = Net income/shareholders equity
In a scenario where a group is publicly listed, but where certain subsidiaries of the group are partially owned by other groups, the formula can be amended as follows to produce a value specific to the equity holders of the public company. However, this is an advanced definition that will only be useful for professional practitioners.
ROE = Net income attributable to majority interest/(shareholders’ equity – equity attributable to noncontrolling interest)
It is important to understand what return on equity does and does not show. It gives a factual measurement of the level of profits a business generated from a finite level of input capital. It does not, however, show the level of return that a retail investor would have experienced if they had bought the shares of the company and sold them after the applicable period. This is because the profit enjoyed by a stock market investor is dependent upon two factors – the dividend yield and the change in the market price of the shares.
These are not the same data as the inputs to the ROE calculation – net income and shareholders equity. Let’s explore why:
- Accounting net income is the book value of the increase in net assets of a company during a period. A portion of this income may be paid out as a dividend to shareholders, but it is extremely rare for a company to distribute all of its income as a dividend. Corporations prefer to retain some profits to invest in future growth, payment of debts and fund capital expenditure etc.
- The book value of shareholders’ equity is a historical amount that represents the cash originally injected into the business when it originally issued its shares. The price paid (and received) by a shareholder when buying and selling shares on the stock market is its secondary market value which fluctuates each working day.
To quickly illustrate the difference between the return on equity and a shareholders’ real return, picture a scenario in which a successful business generates $10m of profit using shareholders funds of $30m. This gives a return on equity of 33% in the year.
At the same time, a shareholder could have purchased shares at a price of $50 at the beginning of the year. However, as the months passed, the future outlook for the business may have deteriorated due to economic events, resulting in the share price of the company actually falling in value.
In this example, we have shown how a business with a lucrative return on equity could have actually produced a negative return to a stock market investor over the same period.
Cost of capital
The cost of capital is a measure of how much a business needs to pay (as a percentage) for each unit of capital it receives from equity investors and lenders, including bondholders. It is calculated as a blended calculation, combining the cost of borrowing from lenders and receiving investment from equity holders. These two costs are weighted according to the value of debt and equity used by the business.
It is relatively straightforward to measure the cost of debt; this can be read from the financial statements of a company. The value of interest incurred on all debt, relative to the average debt burden of the company throughout the year will yield a percentage cost of debt.
The cost of equity is not readily determinable in the same manner. While dividends are recorded in a visible manner in the financial statements, this is only one component of the total return to shareholders. While they are not distributed in cash terms, retained earnings also provide an indirect return to shareholders, as they can be reinvested to grow the business (and therefore dividends) in future periods. This leads to a theoretical increase in the share price when a business retains its earnings. The cost of equity can be approximated using the Capital Asset Pricing Model (CAPM) which we will not cover separately in this article.
Cost of capital is a useful ratio for the financial managers of an organization because it allows them to find the optimal mix of equity and debt which produces the lowest overall cost of capital. Management books for financial managers reiterate that a low cost of capital is ideal because this allows the business to tap into the cheapest financing options compared to its competitors.
If the cost of capital is higher than the expected return from a new project, then a company will not pursue the project. It follows that the lower a companies cost of capital, the more viable investment opportunities it can pursue.
Difference between return on equity and cost of capital
Both ratios gauge the level of return that a business produces relative to the amount of money it uses to finance itself. Four key points of difference between a return on equity and the cost of capital are as follows:
1. Stakeholder perspective
- Return on equity provides a measure of performance purely from the perspective of an equity holder.
- Cost of capital blends the returns to equity and debt holders together to communicate a figure which reflects how profitable a business is relative to all sources of finance.
2. Book versus market
- Return on equity relies upon accounting information that is historical in nature. For example, shareholders equity is the historic value of cash invested into the business, rather than the current market value of its shares.
- Cost of capital reflects current market factors, such that it communicates information about the expectations of current market participants.
3. Internal versus external use
- Cost of capital is a ratio prized by financial managers within a corporation. It helps a CFO or CEO make the decision as to whether to pursue a new project which will require funds.
- In contrast, return on equity is a ratio to help current and prospective investors understand the track record of the business in generating returns for investors.
4. Historic versus current indicator
- Return on equity is not a return that an investor can expect to earn from now onwards if they buy the shares of a company in question. This is because the denominator in the calculation is the book value, not the current market price, of the equity which is financing the business. The cost to acquire shares on the open market in the current day will typically be much higher than the historical cost, meaning that the same level of profitability would translate to a low return amount.
- The cost of capital gives a useful and current indication of how expensive it is for a corporation to borrow or raise new funds. Therefore it is useful for decision-making purposes.
Return on equity is a useful measure of profitability, relative to the original capital staked by shareholders in the business at inception. It provides a comparable figure which can be used to determine if the business is providing a better rate of return on its assets in one year compared to another.
Cost of capital is a holistic measurement that seeks to understand how risky the financial markets believe a company is. By using market data, it communicates how much return bondholders and shareholders demand from a company to compensate them for the risk they are taking.