Equity Securities and Company Value | CFA Level I Equity Investments

In this lesson, we’ll explore the relationship between equity securities and company value. We’ll cover the role of equity in a company’s operations, the difference between market value and book value of equity, understanding ROE, and discuss the cost of equity and investors’ required rate of return.

The Role of Equity in a Company’s Operations

Companies issue equity for several reasons:

• Raising capital to finance business activities
• Ensuring the company continues to operate as a going concern
• Increasing a firm’s liquidity

The ultimate goal of all these activities is to increase the company’s net income, which in turn increases shareholder wealth.

Market Value vs. Book Value of Equity

The book value of equity is the difference between the total assets and total liabilities of the firm. The market value of equity is the total value of a firm’s outstanding equity shares based on market prices.

Book value reflects a firm’s past and present performance, while market value reflects the market’s consensus view of the firm’s future performance.

The price-to-book (P/B) ratio is the market value of a firm’s equity divided by the book value of its equity. A high P/B ratio reflects strong optimism in future growth.

Understanding Return on Equity (ROE)

ROE is calculated as:

(Net Income – Preferred Dividends) / Average Book Value of Common Equity

or

(Net Income – Preferred Dividends) / Beginning-of-Year Book Value of Equity

A high ROE is generally a favorable reflection of a firm’s effectiveness, but it’s important to examine the reason for an increase.

Cost of Equity and Investors’ Required Rate of Return

When a company issues securities, there is a cost associated with the capital that is raised. The cost of equity is much harder to estimate than the cost of debt.

Investors require a return on the funds they provide to the company, called the investor’s minimum required rate of return. The company’s cost of equity is equal to the investor’s minimum required rate of return.

Two models commonly used to estimate a company’s cost of equity or investors’ minimum required rate of return are the dividend discount model and the capital asset pricing model.