What is the Difference Between Cost of Equity and Return on Equity?

The difference between cost of equity and return on equity lies in their definitions, calculations, and purposes. Here are the key differences:

1. Definition:

• Return on Equity (ROE) is a financial ratio that measures a company's profitability in relation to the equity invested in it.
• Cost of Equity (COE) is the required rate of return that shareholders expect for investing in a company.

1. Perspective:

• ROE is from the company's perspective, reflecting its financial performance and efficiency.
• COE is from the investor's perspective, representing the expected compensation for their investment risk.

1. Calculation:

• ROE is calculated using the formula: Net Income / Shareholder's Equity.
• COE can be calculated using various models, such as the dividend capitalization model or the capital asset pricing model (CAPM).

1. Purpose:

• ROE is used by shareholders and investors to assess the company's financial health and profitability.
• COE is used by companies to determine the minimum rate of return required for their investments or projects, and to make strategic decisions.

In summary, ROE is a measure of a company's financial performance, while COE represents the expected return for investors. Companies with a high ROE relative to their COE are considered to be creating value, while those with a low ROE compared to their COE may be destroying value.

Comparative Table: Cost of Equity vs Return on Equity

The difference between the cost of equity and return on equity lies in their definitions and purposes. Here is a table summarizing the key differences:

Cost of Equity	Return on Equity (ROE)
Represents the rate of return required by investors for investing in a company's equity.	Measures the efficiency of a company's management in generating income and growth from its equity investments.
Also known as the required rate of return.	Used to compare a company's performance with its competitors and the overall market.
Can be calculated using the CAPM (Capital Asset Pricing Model) or Dividend Capitalization Model.	Calculated using the formula: ROE = Shareholder Equity / Net Income.
Takes into account the risk associated with equity investments.	Indicates how well a company is utilizing its shareholders' equity.
Affects the company's decision to raise new capital.	Helps investors determine how efficient a company's management is at generating income and growth from its equity.

In summary, the cost of equity represents the minimum rate of return required by investors for investing in a company, while return on equity measures the efficiency of a company's management in generating income and growth from its equity investments. When the cost of equity is lower than the ROE, the company is creating shareholder value.