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
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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