If you're in the bank industry or talk shop with enough people who are, then you probably know that most lenders strive to earn a return on equity of at least 10%. But beyond the fact that a higher return on equity is obviously better for investors, what's so magical about the 10% threshold?
The answer is simple in theory but complex in practice.
In theory, a bank strives to earn a return on equity of at least 10% because that's what it takes to satisfy investors -- or, to be a bit more technical, because 10% equates roughly to the industry's average theoretical cost of common equity.
I emphasize "theoretical" because most people assume, and not entirely incorrectly, that common equity is free. That is, unlike bonds, deposits, or preferred stock, a bank doesn't have to pay interest to holders of its common stock.
This is why the cost of equity is said to be implied and not explicit. And more specifically, it's implied from the rate of return that's supposedly necessary to maintain a share price that's suitable to stockholders, including the bank's executives, who are often major owners in their own right.
Here's how Investopedia explains it:
Common shareholders expect to obtain a certain return on their equity investment in a company. The equity holders' required rate of return is a cost from the company's perspective because if the company does not deliver this expected return, shareholders will simply sell their shares, causing the price to drop. The cost of equity is basically what it costs the company to maintain a share price that is theoretically satisfactory to investors.
While determining the precise rate of return needed to maintain a specific share price is probably more akin to astrology than astronomy, the calculation is nevertheless designed to account for two general concepts.
The first is the risk-free rate of return. This is the rate of return investors can earn from buying short-term Treasury bills, and, most commonly, the three-month T-bill. And the second concept incorporates the risk premiums associated with investing in stocks generally (systematic risk) and in a specific company in particular (unsystematic risk).
The underlying idea is that a bank must generate a large enough return over short-term T-bills to compensate its investors for the systematic and unsystematic risks they're assuming by holding the stock. And that return is generally assumed to be 10%.
Thus, while it's tempting to conclude that a 10% return on equity is great -- consider, for instance, that the bank industry in aggregate generated a 9% return on equity in the most recent quarter -- that's only just enough to satisfy the theoretical cost of common equity. As a result, if you're looking for a bank that will produce long-term value in excess of this benchmark, then you'll need to set your sights higher.
John Maxfield has no position in any stocks mentioned. The Motley Fool recommends and owns shares of Apple and Bank of America. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.