ROE vs COE - Measuring Return on Equity and Cost of Equity

Investors and analysts measure the performance of bank holding companies by comparing return on equity (ROE) against the cost of equity capital (COE). If ROE is higher than COE, management is creating value. If ROE is less than COE, management is destroying value. Bank value is determined by comparing its stock price to its book value, and then, compared to the spread between ROE and COE.

The wider the spread between ROE and COE, the higher the valuation of price compared to book value. For example, the value of increasing a positive spread (ROE less COE) by 100 basis points adds an estimated 12.5 basis points to the market capitalization to equity ratio.

Some argue this method is flawed because of the various ways ROE and COE can be calculated. As an example, banks generally believe returns should be measured on tangible equity, excluding goodwill, and other intangible assets. This exclusion generates a higher tangible ROE, but lower tangible book value. It also distorts the spread between ROE and IDCFP's COE.

Our Approach to Measuring Cost of Equity

Some analysts use a standard of 10 percent COE when measuring the cost of capital. IDC Financial Publishing, however, uses the long-term U.S. Treasury yield plus one-half of that yield, adjusted for bank specific risk.

The high correlation of market capitalization/book common equity compared to IDCFP's spread of ROE less COE for large bank holding companies demonstrates how price-to-book value can be calculated accurately both at a static point in time and how changes in the ROE-to-COE spread creates dynamic changes in bank valuations over time.

Latest Bank Valuations

Valuations for select large bank holding companies as of May 20, 2019:

It is important to note the significant decline in the 30-year Treasury bond yield since October 2018. The sharp decline in the U.S. 10-year T-note yield from 3.22% to 2.2% at the end of May 2019 reduced the 30-year T-bond yield from 3.4% to 2.7%. This was a result of the U.S. 10-year yield reacting to a collapse of the German 10-year yield from a positive 0.6% to a negative 0.18% in May 2019. The German 10-Year yield also fell to -0.18% in March 2016.

Bank ROEs tend to be limited by declining long-term yields, reducing interest income from loans. The high level of the federal funds rate and, therefore, deposit costs, further reduces bank margins.

For rankings of individual financial institutions, visit our online portal.

To learn more about our methodology for ranking financial institutions or for a copy of this article, please contact us at 800-525-5457 or info@idcfp.com.

John E. Rickmeier, CFA, President, jer@idcfp.com

Robin Rickmeier, Marketing Director