Equity Investments II

Reading 39. Overview of Equity Securities

Learning Outcome Statements

f. explain the role of equity securities in the financing of a company's assets;

g. distinguish between the market value and book value of equity securities;

h. compare a company's cost of equity, its (accounting) return on equity, and investors' required rates of return.

CFA Curriculum, 2020, Volume 5

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Subject 6. Equity Securities and Company Value

Companies issue equity securities to raise capital and increase liquidity. The book value of a company's equity can be affected by its management directly, but the market value is determined by investors. Increases in book value may not be reflected in the company's market value. In fact, book value and market value are rarely equal.

Accounting Return on Equity

ROE is net income (available to common shares) divided by the total book value of equity (common shares).

The book value can be the book value at the beginning of the period or the average book value.

Apparently management's accounting choices (e.g., FIFO versus LIFO) can have a big impact on computed ROEs.

An increasing ROE is not always good. Investors should examine the source of changes in the company's net income and shareholders' equity over time to determine why its ROE is increasing.

A company's price-to-book ratio can be used to indicate investors' expectations for the company's future cash flows generated by its positive net present investment opportunities. The ratio should be used to compare companies mainly in the same industry.

The Cost of Equity and Investor's Required Rate of Return

The cost of debt is simply the periodic coupon rate or interest rate. The cost of equity, which is usually used as a proxy for investors' minimum required rate of return, is difficult to estimate because there is no existing one. Two models can be used to estimate the cost of equity: DDM and CAPM.

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