Return on Equity
Return on equity (ROE) is used to measure rate of return in ownership interest (Shareholder’s equity) of common stock owners. ROE is used to measure the efficiency of a firm at profit generation for every unit of its shareholders’ equity which is also referred to as net assets. It shows whether a company has used its investment funds for purposes of generating earning growth. ROEs that are between 15 and 20 percent are normally deemed good.
ROE is also known as return on capital and the formula used to calculate it is:
ROE = Annual Net Income
Average Stockholders’ Equity
The net income is what is earned after deduction of tax income whereas the average shareholder equity is calculated through division of the total of shareholder’s equity at the start and end of year two.
ROE is important because it aids in measuring the profitability of any company. High values are favorable as they mean the company is generating income on all its new investments. Investors are supposed to compare return on equity of diverse companies in order to determine what their ROE trend is over a particular duration. However, it is important to note relying on ROE solely while making investment decisions isn’t safe. This is because there are instances when the ROE is influenced artificially by management, for instance when debt financing gets used to reduce share capital therefore increasing ROE even though the income is constant.
A high return on investment does not offer any immediate benefit. Because stock prices are mostly determined by EPS (Earnings per share) one pays twice as much for a 20 percent return on Investment Company for a 10 percent return on Investment Company.
The benefit of ROE comes from the reinvestment of the earnings in a company with a high ROE rate which gives the company a growth rate that is high in return. The benefit can also arise from dividend on the common shares or combination of reinvestment and dividends in a company. ROE is broken down into 3 important components by the DuPont formula.
The formula is a strategic profit model and essentially, the return on investment equals the net margin which is multiplied by asset income multiplied by the financial leverage. Splitting ROE in 3 parts makes it easy to understand changes that occur in ROE over a given duration. For instance, when the net margin rises, every sale will bring more money resulting to a high overall ROE. Also, if the asset income increases, the company is able to generate more sales for all the unit assets owned resulting to a high overall ROE.
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