Return on Equity and Cost of Equity for a small business ? Ottawa ...

The Return on Equity (RoE) for a small business (pre-tax) should be easy to calculate. It is:

• Profit for the year (P)
• Average of beginning and ending shareholder equity. (E)

So the RoE for a small privately held business is

So, hypothetically, a business that generates a pre-tax profit of $50,000 and has an average equity of $400,000 (beginning equity plus closing equity that includes the profit/2) should have an RoE of 13%. This seems pretty good.

However it is another matter if we compare the Cost of Equity for a small business to the RoE for the business. There are no publicly available benchmarks for a business such as yours and most small businesses do not pay dividends. Now what?

The formula for calculating the cost of equity for a company is:

CoE = RFR + beta(MR ? RFR)

CoE = cost of equity

RFR = risk free rate of return ? 10 year Canada bonds = 1.9% in Oct 2012

MR = return generated last year for TSX 100 = 6%

Beta is difficult to determine. Beta is a metric that measures the volatility of a stock to the movement of the stock market. A beta of 1.5 signifies that this stock will be far more volatile than the market as a whole. There is no market ?beta? for a small company so the traditional beta is out as a measurement.

I teach small business accounting and I tell my students to look at the capital structure of a small business. This is found by looking at the right side of the balance sheet. The short and long term liabilities (capital) is provided by outsiders and shareholder loans and shareholder equity is provided by insiders. The ratio of outside capital to inside capital results in a quotient that I call beta. It is an amalgam of several risks, some related to the economy, some related to the specific sector and some as a result of poor management decision making.

If we look at a business where outsider capital is 3 times insider capital, we have a beta of 3. If we applied this to our formula above we would have a cost of equity of:

CoE =? 1.9% +3(6-1.9)

=? 1.0% + 14.7%

=? 15.7%

This figure may be too low. However it can be easily seen that the cost of equity can exceed the return on equity.

If we return to our initial example where the business owner crowed over a 13% RoE for his business but his cost of equity was 15.7% then he wasn?t keeping the business ahead of the curve. Simply put, the business was not creating value.

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Source: http://bizz2bizz.wordpress.com/2012/10/20/return-on-equity-and-cost-of-equity-for-a-small-business/

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