Return on Equity

5 Key excerpts on "Return on Equity"

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  Corporate Finance

  Theory and Practice in Emerging Economies

  • Sunil Mahajan(Author)
  • 2020(Publication Date)
  • Cambridge University Press

    (Publisher)

  Short-term lenders prefer liquidity and, therefore, are keen to know the current ratio and the quick ratio. No single ratio or set of ratios can be appropriate for all occasions and purposes. The ratios we calculate and analyse should be appropriate for our objectives, be it performance evaluation, credit analysis or equity investment. Ratios are just numbers that tell us nothing by themselves. The interpretations of these numbers is critical and we must compare ratios across industries and over time in order to draw legitimate conclusions. Let us try and look at ratios differently, basing our analysis on the Return on Equity (ROE). It is a key parameter of performance. Given the risk profile of the company, managers try to maximize the return investors get on their equity investments. Let us see how different ratios dovetail into and capture the ROE. CHAPTER 13 300 | Corporate Finance Return on Equity (ROE) The ROE is defined as the net profit divided by the shareholders’ equity. ROE = net profit/shareholders’ equity. Which can be expanded as follows: ROE = (net profit/sales) * (sales/assets) * (assets/shareholders’ equity). Profit margin Asset turnover Financial Leverage Return on Equity is thus determined by the following three parameters: 1. Profit margin: It is the difference between the sales price and the cost of the products. In a sense, this is the basic reason for the existence of the company; the fact that its products create value and thus are sold at a price that is higher than the cost. Every company tries to increase the margin on sales and, usually, the higher the profit margin, the better the performance. 2. Asset turnover: Investments of the company are in the form of long-term assets and net working capital. These assets are essential for running the business. The sales that can be generated from the invested capital determine the asset turnover. Higher the sales that can be generated with the assets, the better the performance.

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  Financial Literacy

  • Richard A. Lambert(Author)
  • 2016(Publication Date)
  • Wharton Digital Press

    (Publisher)

  all the suppliers of capital—both investors and creditors. How much of this do shareholders get? The answer depends on the capital structure of the firm; that is, the mix of debt and equity. Debt holders supply some of the capital the firm uses to acquire assets. In return, some of the money that the assets generate goes to debt holders in the form of interest payments. Shareholders get the rest. We call the return the shareholders get on the amount they invested the firm’s Return on Equity (ROE), which is defined as:

  The profitability measure is Net Income; this is the return that goes to the shareholders. Similarly, the investment measure is what has been provided by shareholders. As with ROA, it is preferable to use the average balance for Stockholders’ Equity throughout the period in order to take into consideration the inflow or outflow of shareholders’ investment throughout the period.

  A Benchmark for ROE: Cost of Equity Capital

  What’s the relevant benchmark for an acceptable ROE? Because there are no explicit payments owed to equity holders, a common misconception is that equity capital is free. This is completely wrong; the relevant rate of return is the amount that shareholders could get in the marketplace for investments with identical risk. Because the claims of debt holders get paid first, equity is a riskier claim than is debt. Therefore equity investors demand a higher rate of return as compensation for this risk; equity capital is more expensive than debt capital. This means the benchmark for ROE is generally higher than the WACC.

  There is less agreement as to how to measure risk from the perspective of equity holders than there is for debt holders. One of the most widely used approaches, called the Capital Asset Pricing Model (or CAPM for short), is based on the idea that some risks are diversifiable and some are not. Diversifiable risks are those that can be greatly reduced (or even eliminated) by shareholders by holding a well-diversified portfolio of firms. Therefore, these risks are not priced in the marketplace; shareholders do not demand an extra premium to invest in firms whose profits are affected by these kinds of risks or uncertainties.

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  Applied Corporate Finance

  • Aswath Damodaran(Author)
  • 2014(Publication Date)
  • Wiley

    (Publisher)

  Investment Decision Rules 191 Return on Equity The Return on Equity looks at the return to equity investors, using the accounting net income as a measure of this return. Again, defined generally, Return on Equity = Net income Average book value of equity investment in project To illustrate, consider a four-year project with an initial equity investment of $800, and the following estimates of net income in each of the four years: Net Income $140 $170 $210 $250 BV of Equity $800 $700 $600 $500 $400 0 1 2 3 4 Return on Capital = 140/750 18.67% = 170/650 26.15% = 210/550 38.18% = 250/450 55.56% Like the return on capital, the Return on Equity tends to increase over the life of the project, as the book value of equity in the project is depreciated. Just as the appropriate comparison for the return on capital is the cost of capital, the appropriate comparison for the Return on Equity is the cost of equity , which is the rate of return equity investors demand. Decision Rule for ROE Measure for Independent Projects If the Return on Equity > Cost of equity → Accept the project If the Return on Equity < Cost of equity → Reject the project The cost of equity should reflect the riskiness of the project being considered and the financial leverage taken on by the firm. When choosing between mutually exclusive projects of similar risk, the project with the higher Return on Equity will be viewed as the better project. I LLUSTRATION 5.9 Estimating Return on Equity: Vale Consider again the analysis of the iron ore mine that we started in Illustration 5.6. Table 5.11 summarizes the book value of equity and the estimated net income (from Exhibit 5.3) for each of the next ten years in millions of U.S. dollars. To compute the book value of equity in each year, we first compute the book value of the fixed assets, add to it the book value of the working capital in that year, and subtract out the outstanding debt.

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  The Economist Guide To Analysing Companies 6th edition

  • Bob Vause(Author)
  • 2014(Publication Date)
  • Economist Books

    (Publisher)

  Which figure to take from the balance sheet to represent the shareholders’ stake or investment in the business is more problematic. In most balance sheets the shareholders’ total funds are defined as equity. Preference shares or other non-voting capital are often found within the figure for equity. Strictly, these should be removed in the calculation of shareholders’ returns, because it is only the ordinary shareholders, the owners of the company, that are being considered here, not other providers of long-term finance and capital.

  The figure for shareholders’ funds may have several different labels attached to it: Net assets = total assets – (current liabilities + debt) Capital employed = net assets Equity = capital employed Equity = capital employed = net assets Once the shareholders’ investment has been identified it is possible, using the after-tax profit, to calculate an appropriate rate of return. This rate of return may be defined as:

  • return on capital (ROC);
  • return on capital employed (ROCE);
  • return on shareholders’ funds (ROSF);
  • Return on Equity (ROE);
  • return on investment (ROI);
  • return on net assets (RONA).

  Earnings per share

  Investors often make use of earnings per share (EPS) as a measure of the overall profitability of a company. EPS is normally to be found in the income statement (see Chapter 3 ). As with any pre-calculated ratio appearing in an annual report, care should be taken to discover precisely how it has been derived. Also remember EPS is backward looking as it is based on historical profitability. The basis of an EPS calculation is:

  EPS = after-tax profit ÷ the number of shares in issue

  This effectively links profit with a single share. If you owned one company share, how much profit did the company earn – but not necessarily pay out – for you in the year? Inevitably problems can arise in defining what income was really available to shareholders and how to define a share. IAS 33 (similar to FAS 128) deals with the calculation and presentation of EPS figures. Earnings is defined as the after-tax profit (less any minority interests and preference dividends) for the year – the profit attributable to ordinary shareholders.

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  Integrated Bank Analysis and Valuation

  A Practical Guide to the ROIC Methodology

  • S. Chen(Author)
  • 2013(Publication Date)
  • Palgrave Macmillan

    (Publisher)

  In understanding what makes a bank tick, we have found it useful to break down the return on invested capital analysis into two main parts: (1) the bank’s operating performance on a risk-adjusted basis (measured as underlying returns on risk-weighted assets, RORWAs), and (2) its capital leverage (measured as RWA/Invested Capital). Multiplying these two factors together gives us Return on Invested Capital (ROIC).

  In many ways, this echoes a DuPont-style ROE analysis. The DuPont approach breaks down ROE (Return on Equity) into its main components with the following formula: DuPont ROE decomposition:

  ROE =

  (Net Income/Sales) × (Sales/Total Assets) × (Total Assets/Shareholders’ Equity)

  Where Net Income/Sales is the net profit margin, Sales/Total Assets is the asset turnover, and Total Assets/Shareholders’ Equity is the leverage component. Similarly, the ROIC approach breaks down ROIC (return on invested capital) into its main components with the following formula: ROIC decomposition:

  ROIC =

  (Net Returns/Risk-Weighted Assets) × (Risk-Weighted Assets/Invested Capital)

  Where Net Returns/Risk-Weighted Assets is the net risk-adjusted profit margin, and Risk-Weighted Assets/Invested Capital is the capital leverage component.

  Looking at it in this way, analysing bank performance tends to be a discussion of either (1) what‘s driving changes in operating performance (RORWA components), or (2) whether capital leverage (RWA/Invested Capital ratios, and within Invested Capital the debt capital/equity capital funding mix) is rising or falling. We have found this a simpler, clearer way of analysing a bank’s performance.

  The fundamental link between analysis and valuation: value creation

  The key link between analysis and valuation in the ROIC methodology is value creation (or destruction). If a bank’s return on invested capital (ROIC) is higher than the cost of that capital (WACC), then it is deemed to be creating value in that period; if its ROIC is below its WACC, it is deemed to be destroying value.

  The ROIC methodology adds up a bank’s future value creation/destruction period-by-period, discounting it back to net present value. This net present value of future value creation/destruction is then added to (or subtracted from) current invested capital to derive a fundamental valuation for the bank.

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