Difference Between Return on Equity and Cost of Equity (With Table)

Both the term Return on Equity and Cost of Equity includes Equity that is the only thing common between them, and except this, there is no similarity between them both. Both of these have different calculation methods and importance. Along with these, they have other uses and limitations too.

Return on Equity vs Cost of Equity

The difference between Return on Equity and Cost of Equity is that the Cost of Equity is the return required by any company to invest or return needed for investing in equity by any person. In contrast, the return on equity is the measure through which the financial position of a company is determined.

Return on Equity is a measure through which the financial position of a company is determined; it can be calculated for any company with one requirement that is both things required in the formula should be in positive numbers. Therefore it is calculated by dividing the net income of the company with the shareholder’s equity.

From a company’s point of view, the return required for investing or project and from an individual point of view, the return needed to invest in equity shares is the cost of equity. Two methods are used to calculate it, the capitalization method and the capital asset pricing method.

Comparison Table Between Return on Equity and Cost of Equity

Parameters of ComparisonReturn on EquityCost of Equity
DefinitionIt is a measure to determine the financial position.It is either return required for investing by a company or return required for equity investing by an individual.
CalculationNet Income/ shareholder’s equity Two Methods: Dividend Capitalization Method and asset pricing method.
ImportanceHelpful in determining how much profit a company can generate from its shareholders’ investment.Helpful in determining the value of an equity investment.
UseSustainable Growth Rate and Dividend Growth Rate.Use to determine whether the investment is meeting the capital requirement or not.
LimitationHigher Return to Equity often indicates risk.The Dividend capitalization model can only be used if the company pays a dividend.

What is Return on Equity?

Return on Equity is a method to calculate the financial position of a company. It is used to compare the company’s performance with the market and to check whether the money invested by the shareholders is being managed properly or not. It can be calculated for any company only thing required is that the net income and equity should both be positive numbers.

The formula for calculating the Return to equity is:

Net Income/Shareholders’ Equity

Return on Equity can help estimate sustainable growth and dividend growth rates.

  1. Sustainable Growth Rate: a model derived from ROE is used to measure the stock that may be risky and estimate the future, which is essential to be ahead of their ability.
  2. Dividend Growth Rate: The Payout ratio is multiplied with the ROE to measure the Dividend Growth rate.

Although high ROE is good, sometimes it can lead to some risks, such as Inconsistent Profits, Excess Debts, and Negative Net Income.

What is Cost of Equity?

Cost of equity, for a company, is the return required for investing and from an individual point of view, is the return necessary to invest in equity.

The primary and most important use of calculating the cost of equity is determining whether the investment meets the capital requirement or not, which is very necessary for any company.

There are two methods by which calculation of the cost of equity is done:

  • Dividend Capitalization method: DPS is divided by the CMV, and then GRD is added.

DPS: Dividends per share for next year,

CMV: current market value of stock

GRD: growth rate of dividends

  • Capital asset pricing method: E(Ri) = Rf + βi * [E(Rm) – Rf]

E(Ri): Expected return on asset I

Rf: Risk-free rate of return

βi: Beta of asset I

E(Rm): Expected market return

The only limitation Cost of Equity has is that if it is calculated with the Dividend Capitalization Method, the company must pay a dividend.

Main Differences Between Return on Equity and Cost of Equity

  1. Return on Equity is a measure through which a company determines its financial position. In contrast, in simple terms, the Cost of Equity defined as the value of equity investment returned for an individual and the return value required for investing or a project for a company.
  2. Return on Equity can be calculated by simply dividing the Net Income of the company with its shareholder’s equity whereas there are two methods for calculating the Cost of Equity; these are Dividend Capitalization Method and Capital Asset Pricing Method.
  3. Return on Equity is essential to determine the profit company can generate from its shareholders’ investment. In contrast, the Cost of Equity is essential to know that the actual value of equity investment in the capital.
  4. Return on Equity is used to measure the Sustainable Growth and Dividend Growth rate using the Sustainable Growth Rate Model and Multiplying ROE with payout ratio, respectively. In contrast, the Cost of Equity is used to determine whether the investment is meeting the capital requirement or not.
  5. Limitation of Return on Equity is that the higher ROE can lead to some risks, including Inconsistent Profits, Excess Debts, and Negative Net Income. In contrast, the only limitation with Cost of Equity is its calculation method in the Dividend Capitalization Method.

Conclusion

Therefore, it is clear that both of the terms are related to Equity. Still, Return on Equity and Cost of Equity is not the same at all. On one side, the return on equity determines the financial position or how much profit the company is generating. On the other side cost of equity is the actual value of the investment made in equity. Every company calculates both Return on Equity and Cost of Equity irrespective of its size and type. These are very important for any company, and it is essential to calculate them to know the future growth and future requirements respectively.

References

  1. https://papers.ssrn.com/sol3/papers.cfm?abstract_id=258702
  2. https://www.jstor.org/stable/248475
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