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Encyclopedia > Return on equity

Return on Equity (ROE, Return on average common equity) measures the rate of return on the ownership interest (shareholders' equity) of the common stock owners. ROE is viewed as one of the most important financial ratios. It measures a firm's efficiency at generating profits from every dollar of net assets, and shows how well a company uses investment dollars to generate earnings growth. ROE is equal to a fiscal year's net income (after preferred stock dividends but before common stock dividends) divided by total equity (excluding preferred shares), expressed as a percentage. In business and accounting, the shareholders equity refers to the amount of assets that are owned by a companys shareholders. ... A financial ratio is a ratio of two numbers of reported levels or flows of a company. ... Net income is equal to the income that a firm has after subtracting costs and expenses from the total revenue. ...

[1]

But not all high-ROE companies make good investments. Some industries have high ROE because they require no assets, such as consulting firms. Other industries require large infrastructure builds before they generate a penny of profit, such as oil refiners. You cannot conclude that consulting firms are better investments than refiners just because of their ROE. Generally, capital-intensive businesses have high barriers to entry, which limit competition. But high-ROE firms with small asset bases have lower barriers to enty. Thus, such firms face more business risk because competitors can replicate their success without having to obtain much outside funding. As with many financial ratios, ROE is best used to compare companies in the same industry. Management consulting (sometimes also called strategy consulting) refers to both the practice of helping companies to improve performance through analysis of existing business problems and development of future plans, as well as to the firms that specialize in this sort of consulting. ... View of Shell Oil Refinery in Martinez, California. ... A financial ratio is a ratio of two numbers of reported levels or flows of a company. ...


High ROE yields no immediate benefit. Since stock prices are most strongly determined by earnings per share (EPS), you will be paying twice as much (in Price/Book terms) for a 20% ROE company as for a 10% ROE company. The benefit comes from the earnings reinvested in the company at a high ROE rate, which in turn gives the company a high growth rate.


ROE is irrelevant if the earnings are not reinvested.

  • The sustainable growth model shows us that when firms pay dividends, earnings growth lowers. If the dividend payout is 20%, the growth expected will be only 80% of the ROE rate.
  • The growth rate will be lower if the earnings are used to buy back shares. If the shares are bought at a multiple of book value (say 3 times book), the incremental earnings returns will be only 'that fraction' of ROE (ROE/3).
  • New investments may not be as profitable as the existing business. Ask "what is the company doing with its earnings?"
  • Remember that ROE is calculated from the company's perspective, on the company as a whole. Since much financial manipulation is accomplished with new share issues and buyback, always redo the calculation on a 'per share' basis. EPS/book.

The DuPont Formula

The DuPont formula, also known as the strategic profit model, is a common way to break down ROE into three important components. Essentially, ROE will equal net margin multiplied by asset turnover multiplied by financial leverage. Splitting return on equity into three parts makes it easier to understand changes in ROE over time. For example, if the net margin increases, every sale brings in more money, resulting in a higher overall ROE. Similarly, if the asset turnover increases, the firm generates more sales for every dollar of assets owned, again resulting in a higher overall ROE. Finally, increasing financial leverage means that the firm uses more debt financing relative to equity financing. Interest payments to creditors are tax deductible, but dividend payments to shareholders are not. Thus, a higher proportion of debt in the firm's capital structure leads to higher ROE. Financial leverage benefits diminish as the risk of defaulting on interest payments increases. So if the firm takes on too much debt, the cost of debt rises as creditors demand a higher risk premium, and ROE decreases. [2] Net margin(also known as Net Profit Margin) is a financial ratio measuring the efficiency of a business in translating sales into net income. ... This article or section does not cite its references or sources. ... Leverage is using given resources in such a way that the potential positive or negative outcome is magnified. ... For other uses, see Debt (disambiguation). ... The Court of Chancery, London, early 19th century This article is about concept of equity in Anglo-American jurisprudence. ... For other uses, see Debt (disambiguation). ... For other uses, see Debt (disambiguation). ... The cost of debt is the cost of borrowing money (usually denoted by Kd). ...

Sources

    1. ^ http://members.shaw.ca/RetailInvestor/metrics.html#roe
  • ^ Woolridge, J. Randall and Gray, Gary; Applied Principles of Finance (2006)

  Results from FactBites:
 
Fool.com: A Definition [Return on Equity] (715 words)
By perceiving return on equity as a composite that represents the executive team's ability to balance these three pillars of corporate management, investors can not only get an excellent sense of whether they will receive a decent return on equity but also assess management's ability to get the job done.
Return on equity is calculated by taking a year's worth of earnings and dividing them by the average shareholder's equity for that year.
Shareholder's equity can be found on the balance sheet and is simply the difference between the total assets and total liabilities, as it is assumed that assets without corresponding liabilities are the direct creation of the shareholder's capital that got the business started in the first place.
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