Cost of Equity

CFA Level II
#1

Should Cost of Equity always be between ROE and EPS growth? I’m thinking in terms of the residual income model: V = B + [(ROE - Ce) / (Ce - g)] * B Where: CoE = Cost of equity V = Intrinsic value B = Book value per share

#2

cjones65 Wrote: ------------------------------------------------------- > Should Cost of Equity always be between ROE and > EPS growth? I’m thinking in terms of the residual > income model: > > V = B + [(ROE - Ce) / (Ce - g)] * B > > Where: > > CoE = Cost of equity > V = Intrinsic value > B = Book value per share yes in ideal scenario

#3

If I understand correctly where you’re going with this question: This formula does not imply that ROE > CoE. You can have CoE > ROE, and this would mean that the firm is in fact destroying value. As for CoE vs growth, hm…

#4

Since growth g = RR x ROE, and you can put RR=1, the same applies to g. CoE can be greater or smaller than g. But if g > CoE then the model breaks down it seems.

#5

if ROE < CoE, then there is no residual income, no value created.

#6

Interesting … I ask because I’ve been backing out implied CoEs for companies that fit the criteria ROE>implied CoE>g (consensus 5-year EPS growth) … … then taking sets of peer groups based on industry and market cap, and comparing the current price to the model’s output after replacing the actual implied CoE with the peer group average implied CoE. I just wondered if I was right to ignore companies that don’t fit the profile of ROE>implied CoE>g