Updated for the 2026-2027 CFA® Level I curriculum.
Cost of equity, accounting return on equity, and investors' required return sound similar but measure different things. Two of them describe the same number from different viewpoints. The third comes from a completely different data source. CFA Level I asks you to keep these three straight and explain why swapping one for another leads to bad conclusions.
Quick Answer
A company's cost of equity and investors' required return are the same figure. Cost of equity is what the company must offer to attract equity capital. Required return is what investors demand for taking on that equity risk. Accounting return on equity (ROE) is different. It measures historical profitability using net income and book value of equity from the financial statements. ROE does not directly measure risk or market expectations, so it is not a substitute for cost of equity.
Key Takeaways About Cost of Equity, Accounting ROE, and Investors’ Required Return
Cost of equity (company view) and investors' required return (investor view) describe the same number from two sides of the same transaction.
Accounting ROE equals net income divided by average book value of equity. It is a historical accounting result, not a forward-looking market estimate.
Cost of equity and required return are typically estimated with models such as the capital asset pricing model (CAPM), using beta and a market risk premium.
ROE uses figures from the income statement and balance sheet. It does not require a market price or a risk model.
Comparing ROE to cost of equity tells you whether a company is creating or destroying value for equity holders, but the two numbers still measure different things.
A high ROE does not mean investors are earning a high required return, and a low ROE does not mean the required return is low.
Level I questions often test whether you can identify which measure applies to a given fact pattern.
What You Need to Know for CFA Level I
Define company cost of equity and explain what it represents.
Define accounting ROE and identify its accounting inputs.
Define investors' required return and connect it to cost of equity.
Explain why cost of equity and required return are conceptually identical.
Explain why ROE is not interchangeable with cost of equity or required return.
Recognize the practical consequence of ROE exceeding or falling short of the required return.
Company Cost of Equity
Cost of equity is the return a company must expect to deliver to equity investors to compensate them for the risk of owning the stock. A company does not set this number directly. It is estimated using market-based models, most commonly the CAPM:
Where:
= cost of equity
= risk-free rate
= the stock's sensitivity to market movements
= expected return on the market
= equity market risk premium
Cost of equity is forward-looking. It reflects current market conditions and the perceived risk of the stock, not past accounting results. Analysts use it as a discount rate in valuation models, including the dividend discount model and other present-value approaches.
Accounting Return on Equity
Accounting ROE measures how much profit a company generated relative to the book value of its equity:
Where:
Net income comes from the income statement over a stated period
Average total equity is typically the average of beginning and ending book value of equity from the balance sheet
ROE is backward-looking. It tells you how the company performed during a past period, using accounting figures rather than market prices. It does not use a risk model, a market price, or an expectation about the future.
Two companies with identical ROE can carry very different levels of risk, because ROE says nothing about how that profit was earned or how risky the underlying business is.
Investors' Required Return
Investors' required return is the minimum return an equity investor demands to hold a stock, given its risk. This is not a separate calculation from cost of equity. It is the same number viewed from the investor's side of the transaction rather than the company's side.
If a company's cost of equity is 9%, that means equity investors require a 9% return to hold the stock at its current risk level. The company must expect to generate at least that return on equity capital, or investors will not be willing to supply it at the current price. This is why CFA materials often present cost of equity and required return using the same formula and the same inputs.
Why the Three Measures Are Related But Not Interchangeable
Cost of equity and required return are the same figure from two perspectives. Accounting ROE is a separate, independent number built from financial statement data rather than market inputs. The relationship between ROE and required return matters for a different reason: it signals whether a company is creating or destroying value for shareholders.
Measure | Data Source | Time Orientation | Perspective |
|---|---|---|---|
Cost of equity | Market inputs (risk-free rate, beta, market risk premium) | Forward-looking | Company raising capital |
Investors' required return | Market inputs (same as cost of equity) | Forward-looking | Investor supplying capital |
Accounting ROE | Financial statements (net income, book equity) | Backward-looking | Historical company performance |
If ROE consistently exceeds the required return, the company is earning more on equity capital than investors demand, which supports value creation. If ROE falls short of the required return, the company is not covering the cost of the equity capital it uses, even if net income is positive. This comparison is useful, but it does not make ROE and required return the same measure. One is accounting profitability. The other is a market-based hurdle rate.
Worked Example
Orlan Fixtures Inc. reports net income of $18 million for the year. Average book value of equity for the year is $150 million. An analyst estimates Orlan's cost of equity using CAPM with a risk-free rate of 4%, a beta of 1.2, and an equity market risk premium of 5%.
Step 1: Calculate accounting ROE
Step 2: Calculate cost of equity using CAPM
Step 3: Compare the two measures
ROE (12.0%) exceeds cost of equity (10.0%), which also equals investors' required return.
Orlan generated an accounting return on its equity that was higher than what investors require for the stock's risk level. This suggests Orlan created value for shareholders during the year. But the 12.0% and 10.0% are not measuring the same thing.
The 12.0% comes from the income statement and balance sheet. The 10.0% comes from a market-based risk model. The comparison is useful, but the numbers stay conceptually distinct.
Common Exam Traps
Using accounting ROE as if it were the market-required return
ROE is a historical, book-value-based profitability ratio. Required return is a forward-looking, market-based hurdle rate. They can differ significantly even for a healthy company.
Treating cost of equity and ROE as interchangeable
Candidates sometimes plug ROE into a valuation model in place of cost of equity. This produces an incorrect discount rate because ROE is not derived from market risk inputs.
Ignoring the perspective from which each measure is defined
Cost of equity and required return are the same number from two sides of one transaction. ROE stands apart because it reflects the company's internal accounting results, not investor expectations.
Comparing percentages without checking what each percentage measures
A 12% ROE and a 12% required return are not automatically consistent conclusions unless you confirm both are measuring the same underlying concept for the same period.
Practice Questions
An analyst calculates that Bricklane Corp. has a return on equity of 14% based on last year's net income and average book value of equity. Using CAPM, the analyst also estimates that Bricklane's cost of equity is 11%. Which of the following statements is most accurate?
Bricklane's required return exceeds its cost of equity, so the company is destroying shareholder value.
Bricklane's accounting ROE exceeded its cost of equity last year, which suggests the company earned more than investors require for the stock's risk.
Because ROE and cost of equity are the same measure, Bricklane's true return to shareholders was 11%.
Correct Answer: B
Cost of equity and investors' required return are the same figure, so Bricklane's required return is 11%, not a separate number. ROE (14%) is a historical accounting measure that exceeded that required return.
This comparison suggests the company generated more accounting profit relative to book equity than investors require for the stock's risk, which is consistent with value creation.
Option A: This confuses cost of equity and required return as if they were two different, opposing figures. They are the same number viewed from two sides.
Option C: This incorrectly treats ROE and cost of equity as identical measures. They come from different data sources and are not interchangeable.
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FAQs About Cost of Equity, Accounting ROE, and Investors’ Required Return
Is cost of equity the same as required return on equity?
Yes. Cost of equity is the term used from the company's perspective. Required return is the same figure from the investor's perspective. Both describe the return equity investors demand given the stock's risk.
Why does not a high ROE mean investors are earning a high required return?
ROE is calculated from net income and book value of equity, both accounting figures. Required return comes from market-based risk models. A company can post a high ROE while its stock still carries a required return based on market risk factors unrelated to that period's accounting profit.
What does it mean if ROE is lower than cost of equity?
It suggests the company earned less on its equity capital than investors require for the risk they are taking, which is a sign of possible value destruction rather than value creation.