Return on equity
Profit as a share of what shareholders put in. Two firms reaching the same figure through margin and through borrowing are not the same proposition.
Where you will meet it
Return on equity appears in 20 learning outcomes on the CFA syllabus. A few of them:
- Contrast market value with book value and link return on equity to the cost of equity
“The bridge between them is the relationship between return on equity and the cost of equity: a company earning a return above its cost of equity creates value and trades above book, one earning below destroys value and trades below.”
- Analyse how the choice of inventory method changes financial ratios
“Return on equity falls too, but by less than profit alone would suggest, because retained earnings are also lower.”
- Work out return on invested capital and explain what it reveals
“Because it is measured before financing costs, it is not distorted by leverage the way return on equity is, which makes it the better guide to operating performance across firms.”
- Work out the value of a common share with the dividend discount model (DDM) over one holding period and over several, and explain the result
“A share is worth the present value of the dividends received while it is held plus the present value of the expected sale price, discounted at the required return on equity.”
Learn it properly
Practise it
Practise return on equity until it is automatic: questions that explain every wrong option.
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