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I am being told that I should compare my CAPM to the ROE generated but the firm. If ROE > CAPM, there is value creation. Yet I fail to see how those two are linked given that ROE is an accounting measure.
Could you please help me out on this?
I don’t know who told you this (and thy they didn’t explain!)
What you should really have been told is that is the return given by CAPM is the return that the share should give, whereas the actual return to shareholders is the return that it is current giving. (The ROE is indeed an accounting measure and is at best just an approximation to the return actually being given).
If the return given by the equity beta is lower then the current actual return, then in time the actual return will fall to that resulting from the equity beta, and since the MV is the PV of the future receipts discounted at the required rate of the return the MV of the shares will increase.
Hi John,
Thank you for your prompt answer. Haha well the reason they didn’t explain is because they didn’t know either, they were just doing as told.
Just to confirm: the market value of the shares is going to increase which will make the current actual return fall to that expected as calculated by the equity beta.
However, the ROE being an accounting measure will not necessarily reflect that since the ROE is calculated on book values of equity, right?
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