Financial Accounting: In an Economic Context

SHAREHOLDER VALUE, ROE, AND CASH FLOW ANALYSES

Management's goal is to create value for the shareholders, the owners of the firm, by generating a return on the shareholders' investment that exceeds the cost of equity —the return the shareholders could have earned if they invested their funds in an equally risky alternative investment. Return on equity (net income/average shareholders' equity) (ROE) defines the return on the shareholders' investment for a given period; therefore, shareholder value creation occurs in a given period if ROE is greater than the cost of equity. If ROE is less than the cost of equity, value has been lost. Management's success is defined by whether it creates shareholder value in the long run.

The cost of equity is very elusive, and even the best economists have been unable to agree on how it should be computed. It is not disclosed on the financial statements or related footnotes because it is simply too subjective. It must be estimated. Some companies discuss their cost of capital estimates in their annual reports, but it remains relatively rare. Most economists agree, however, that the cost of equity contains two components: a risk-free rate of return, which is shared by the entire economy, and a risk premium, which is unique to the particular investment.

Cost of equity = Risk-free rate of return + Risk premium

The rate of return on ten-year government treasury bills as of a particular date is often used to estimate the risk-free rate. Historically, ...