The equity spread calculates the value creation of a company's base capital or equity. It is computed by multiplying the beginning equity capital by the difference between return on equity and cost of capital.
The higher the equity spread, the better. A high equity spread means that equity grew in value by a significant amount due to the big difference between the returns received from investing capital into the business compared to the cost of providing such capital.
The formula in computing for the equity spread is:
| ES | = | Beginning stockholders' equity x (re - ke) |
where:
re = Return on equity = Income / Average Equity
ke = Cost of equity
The stockholders' equity of ABC Company had a beginning balance of $1,200,000 and ending balance of $2,000,000. It generated an operating income of $400,000. The cost of equity is 10%. Compute for the equity spread.
1. Computation of return on equity
| Return on equity | = | Income |
| Average equity | ||
| = | $400,000 | |
| ($1.2M + $2M) ÷ 2 | ||
| Return on equity | = | 25% |
2. Computation of equity spread
| ES | = | Beginning stockholders' equity x (re - ke) |
| ES | = | $1,200,000 x (25% - 10%) |
| ES | = | $180,000 |
Calculating the equity spread requires you to know the return on equity and cost of equity (or capital).
The beginning balance of equity is multiplied by the difference between the two.
