Musings on Markets · 2025-02-18
· 471d
Return on Equity vs. Earnings Yield: Clarifying Market Efficiency Fundamentals
An educational analysis distinguishing return on equity (ROE) from earnings yield, and explaining how efficient markets price companies based on business quality. The author uses two simplified business examples to demonstrate why good companies aren't always good investments, and clarifies common misconceptions about what ROE measures.
Metrics in this report
Cost of Equity
10%
assumed
Equivalent risk for both businesses
Excess Return - Business A
15%
calculated
ROE 25% minus cost of equity 10%
Excess Return - Business B
-5%
calculated
ROE 5% minus cost of equity 10%
Price-to-Book Ratio - Business A
2.50x
fair value
Market value $150M / book value $60M
Price-to-Book Ratio - Business B
0.50x
fair value
Market value $30M / book value $60M
Return on Equity - Business A
25%
calculated
High-quality business with $15M annual income on $60M equity
Return on Equity - Business B
5%
calculated
Low-quality business with $3M annual income on $60M equity