Definition
Cost of Equity (Banking)
Cost of equity is the return shareholders require for the risk of holding a bank's or company's stock, the benchmark its ROE must beat to create value.
Estimated using models like the capital asset pricing model, the cost of equity reflects the risk-free rate plus an equity risk premium scaled by the stock's beta. For a bank, value is created only when sustainable ROE exceeds this cost of equity.
The gap between ROE and cost of equity largely determines the price-to-book multiple a bank deserves: banks earning well above their cost of equity command premium P/B ratios, while those earning below trade at a discount to book.
Related terms
- Price-to-Book (P/B) RatioThe P/B ratio compares a company's market price to its book value (net assets) per share, showing how much investors pay for each rupee of net worth.
- Equity Risk PremiumThe equity risk premium is the extra return investors expect from stocks over risk-free assets, compensating for higher risk.
- Weighted Average Cost of Capital (WACC)WACC is the average rate a company must pay to finance its operations, blending the cost of equity and the cost of debt.
- Return on Equity (ROE) for BanksFor a bank, Return on Equity is net profit as a percentage of average shareholders' equity, reflecting the return generated on the capital owners have invested.
Plain-English explainer from The Dispatch Investors Encyclopedia. General information, not financial advice.