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Equity Spread

Introduction

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.

In a Nutshell

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.

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.

Equity Spread (ES) Formula

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

Example: Calculating the Equity Spread

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
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