Return on Equity (ROE , Return on average common equity , return on net worth , Return on ordinary shareholders' funds ) (requity) measures the rate of return on the ownership interest (shareholders' equity In accounting and finance, equity is the residual claim or interest of the most junior class of investors in assets, after all liabilities are paid. If valuations placed on assets do not exceed liabilities, negative equity exists. In an accounting context, Shareholders' equity represents the remaining interest in assets of a company, spread among ) of the common stock owners. It measures a firm's efficiency at generating profits from every unit of shareholders' equity (also known as net assets or assets minus liabilities). ROE shows how well a company uses investment funds to generate earnings growth.
The formula
[1]
ROE is equal to a fiscal year A fiscal year is a period used for calculating annual ("yearly") financial statements in businesses and other organizations. In many jurisdictions, regulatory laws regarding accounting and taxation require such reports once per twelve months, but do not require that the period reported on constitutes a calendar year (i.e., January 's net income Net income is the remaining income of a firm after adding total revenue and gains and subtracting all expenses and losses for the reporting period. Net income can be distributed among holders of common stock as a dividend or held by the firm as an addition to retained earnings. As profit and earnings are used synonymously for income , Net Earnings (after preferred stock dividends but before common stock dividends) divided by total equity (excluding preferred shares), expressed as a percentage. As with many financial ratios A financial ratio is a relative magnitude of two selected numerical values taken from an enterprise's financial statements. Often used in accounting, there are many standard ratios used to try to evaluate the overall financial condition of a corporation or other organization. Financial ratios may be used by managers within a firm, by current and , ROE is best used to compare companies in the same industry.
High ROE yields no immediate benefit. Since stock prices are most strongly determined by earnings per share In the United States, the Financial Accounting Standards Board requires companies' income statements to report EPS for each of the major categories of the income statement: continuing operations, discontinued operations, extraordinary items, and net income (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 presumably 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 recalculate on a 'per share' basis, i.e., earnings per share/book value per share.
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 the net margin multiplied by asset turnover multiplied by financial leverage In finance, leverage refers to the use of debt to supplement investment. Companies usually leverage to increase returns to stock, as this practice can maximize gains (and losses). The easy but high-risk increases in stock prices due to levering at banks in the United States have been blamed for the unusually high rate of pay for top executives . 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 unit of assets owned, again resulting in a higher overall ROE. Finally, increasing financial leverage means that the firm uses more debt Debt is that which is owed; usually referencing assets owed, but the term can also cover moral obligations and other interactions not requiring money. In the case of assets, debt is a means of using future purchasing power in the present before a summation has been earned. Some companies and corporations use debt as a part of their overall financing relative to equity The stock or capital stock of a business entity represents the original capital paid into or invested in the business by its founders. It serves as a security for the creditors of a business since it cannot be withdrawn to the detriment of the creditors. Stock is distinct from the property and the assets of a business which may fluctuate in financing. Interest payments to creditors are tax deductible, but dividend payments to shareholders are not. Thus, a higher proportion of debt Debt is that which is owed; usually referencing assets owed, but the term can also cover moral obligations and other interactions not requiring money. In the case of assets, debt is a means of using future purchasing power in the present before a summation has been earned. Some companies and corporations use debt as a part of their overall 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 Debt is that which is owed; usually referencing assets owed, but the term can also cover moral obligations and other interactions not requiring money. In the case of assets, debt is a means of using future purchasing power in the present before a summation has been earned. Some companies and corporations use debt as a part of their overall , the cost of debt rises as creditors demand a higher risk premium, and ROE decreases. [2] Return on assets This number tells you what the company can do with what it has, i.e. how many dollars of earnings they derive from each dollar of assets they control. It's a useful number for comparing competing companies in the same industry. The number will vary widely across different industries. Return on assets gives an indication of the capital intensity of (ROA) of that debt exceeds the interest rate on the debt. [3]
See also
Notes
^ http://www.answers.com/topic/return-on-equity Answers.com Return on Equity^ ^
External links
Stock market A stock market or equity market is a public market for the trading of company stock and derivatives at an agreed price; these are securities listed on a stock exchange as well as those only traded privately
Types of stocks
Stock The stock or capital stock of a business entity represents the original capital paid into or invested in the business by its founders. It serves as a security for the creditors of a business since it cannot be withdrawn to the detriment of the creditors. Stock is distinct from the property and the assets of a business which may fluctuate in · Common stock Common stock is a form of corporate equity ownership, a type of security. It is called "common" to distinguish it from preferred stock. In the event of bankruptcy, common stock investors receive their funds after preferred stock holders, bondholders, creditors, etc. On the other hand, common shares on average perform better than · Preferred stock Preferred stock, also called preferred shares, preference shares, or simply preferreds, is a special equity security that has properties of both an equity and a debt instrument and is generally considered a hybrid instrument. Preferreds are senior to common stock, but are subordinate to bonds · Outstanding stock Shares outstanding are common shares that have been authorized, issued, and purchased by investors. They have voting rights and represent ownership in the corporation by the person or institution that holds the shares. They should be distinguished from treasury shares, which is common stock held by the corporation · Treasury stock A treasury stock or reacquired stock is stock which is bought back by the issuing company, reducing the amount of outstanding stock on the open market · Authorised stock Shares authorized is the maximum number of shares that a company can issue. This number is specified in the company's articles of association but can be changed by shareholder approval. A company usually authorizes a higher number of shares than required to be able to issue stock in the future · Restricted stock Restricted stock, also known as letter stock or restricted securities, refers to stock of a company that is not fully transferable until certain conditions have been met. Upon satisfaction of those conditions, the stock becomes transferable by the person holding the award · Concentrated stock Concentrated stock is an equity making up a substantial part of the investor's portfolio. The major risk associated with such a portfolio is a lack of diversification; concentrated stock makes a large portion of the investor's wealth dependent on the performance of one particular stock. The reasons for keeping a concentrated stock may be · Golden share A Golden Share is a nominal share which is able to outvote all other shares in certain specified circumstances, often held by a government organization, in a government company undergoing the process of privatization and transformation into a stock-company
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Investor The term has taken on a specific meaning in finance to describe the particular types of people and companies that regularly purchase equity or debt securities for financial gain in exchange for funding an expanding company. Less frequently, the term is applied to parties who purchase real estate, currency, commodity derivatives, personal property · Stock trader/investor A stock trader or a stock investor is an individual or firm who buys and sells stocks or bonds in the financial markets · Market maker Most foreign exchange trading firms are market makers and so are many banks, although not in all currency markets. In foreign exchange trading, where most deals are conducted over-the-counter and are, therefore, completely virtual, the market maker sells to and buys from its clients and is compensated by means of price differentials and for the · Floor trader A floor trader is a member of a stock or commodities exchange who trades on the floor of that exchange for his or her own account. The floor trader must abide by trading rules similar to those of the exchange specialists who trade on behalf of others. The term should not be confused with floor broker. Floor Traders are occasionally referred to as · Floor broker A floor broker is an independent member of an exchange who can act as a broker for other members who become overloaded with orders, as an agent on the floor of the exchange. The floor broker receives an order via teletype machine from his firm's trading department and then proceeds to the appropriate trading post on the exchange floor. There he · Broker-dealer A broker-dealer is a term used in United States financial services regulations. It is a company or other organization that trades securities for its own account or on behalf of its customers
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Stock exchange A stock exchange is an entity which provides "trading" facilities for stock brokers and traders, to trade stocks and other securities. Stock exchanges also provide facilities for the issue and redemption of securities as well as other financial instruments and capital events including the payment of income and dividends. The securities · List of stock exchanges This is an active list of stock exchanges. Those futures exchanges that also offer trading in securities besides trading in futures contracts are listed both here and the list of futures exchanges · Over-the-counter Over-the-counter or off-exchange trading is to trade financial instruments such as stocks, bonds, commodities or derivatives directly between two parties. It is contrasted with exchange trading, which occurs via facilities constructed for the purpose of trading (i.e., exchanges), such as futures exchanges or stock exchanges · Electronic Communication Network An electronic communication network is the term used in financial circles for a type of computer system that facilitates trading of financial products outside of stock exchanges. The primary products that are traded on ECNs are stocks and currencies. ECNs came into existence in 1998 when the SEC authorized their creation. ECNs increase competition
Stock valuation In financial markets, there are several methods used to calculate theoretical values of companies and their stocks. The main use of these methods is to predict future market prices, or more generally potential market prices, and thus to profit from price movement – stocks that are judged undervalued are bought, while stocks that are judged
Gordon model The Gordon growth model is a variant of the discounted cash flow model, a method for valuing a stock or business. Often used to provide difficult-to-resolve valuation issues for litigation, tax planning, and business transactions that are currently off market. It is named after Myron J. Gordon, who originally published it in 1959. It assumes that · Dividend yield The dividend yield or the dividend-price ratio on a company stock is the company's annual dividend payments divided by its market cap, or the dividend per share, divided by the price per share. It is often expressed as a percentage. Its reciprocal is the Price/Dividend ratio · Earnings per share In the United States, the Financial Accounting Standards Board requires companies' income statements to report EPS for each of the major categories of the income statement: continuing operations, discontinued operations, extraordinary items, and net income · Book value In accounting, book value or carrying value is the value of an asset according to its balance sheet account balance. For assets, the value is based on the original cost of the asset less any depreciation, amortization or impairment costs made against the asset. Traditionally, a company's book value is its total assets minus intangible assets and · Earnings yield Earnings yield is the quotient of earnings per share divided by the share price. It is the reciprocal of the P/E ratio · Beta In finance, the beta of a stock or portfolio is a number describing the relation of its returns with that of the financial market as a whole · Alpha Alpha is a risk-adjusted measure of the so-called active return on an investment. It is the return in excess of the compensation for the risk borne, and thus commonly used to assess active managers' performances. Often, the return of a benchmark is subtracted in order to consider relative performance, which yields Jensen's alpha · CAPM In finance, the capital asset pricing model is used to determine a theoretically appropriate required rate of return of an asset, if that asset is to be added to an already well-diversified portfolio, given that asset's non-diversifiable risk. The model takes into account the asset's sensitivity to non-diversifiable risk (also known as systematic · Arbitrage pricing theory Arbitrage pricing theory , in finance, is a general theory of asset pricing, that has become influential in the pricing of stocks · T-Model When ex post values for growth, price/book, etc. are plugged in, the T-Model gives a close approximation of actually realized stock returns. Unlike some proposed valuation formulas, it has the advantage of being correct in a mathematical sense ; however, this by no means guarantees that it will be a successful stock-picking tool
Financial ratios A financial ratio is a relative magnitude of two selected numerical values taken from an enterprise's financial statements. Often used in accounting, there are many standard ratios used to try to evaluate the overall financial condition of a corporation or other organization. Financial ratios may be used by managers within a firm, by current and
P/CF ratio The price/cash flow ratio , is a ratio used to compare a company's market value to its cash flow. It is calculated by dividing the company's market cap by the company's operating cash flow in the most recent fiscal year (or the most recent four fiscal quarters); or, equivalently, divide the per-share stock price by the per-share operating cash · P/E The P/E ratio of a stock (also called its "P/E", "PER", "earnings multiple", or simply "multiple") is a measure of the price paid for a share relative to the annual net income or profit earned by the firm per share. It is a financial ratio used for valuation: a higher P/E ratio means that investors are · PEG The PEG ratio is a valuation metric for determining the relative trade-off between the price of a stock, the earnings generated per share (EPS), and the company's expected growth · P/S ratio Price-to-sales ratio, P/S ratio, or PSR, is a valuation metric for stocks. It is calculated by dividing the company's market cap by the company's revenue in the most recent fiscal year ; or, equivalently, divide the per-share stock price by the per-share revenue · P/B ratio The price-to-book ratio, or P/B ratio, is a financial ratio used to compare a company's book value to its current market price. Book value is an accounting term denoting the portion of the company held by the shareholders; in other words, the company's total tangible assets less its total liabilities. The calculation can be performed in two ways, · D/E ratio The debt-to-equity ratio is a financial ratio indicating the relative proportion of shareholders' equity and debt used to finance a company's assets. Closely related to leveraging, the ratio is also known as Risk, Gearing or Leverage. The two components are often taken from the firm's balance sheet or statement of financial position (so-called · Dividend payout ratio The part of the earnings not paid to investors is left for investment to provide for future earnings growth. Investors seeking high current income and limited capital growth prefer companies with high Dividend payout ratio. However investors seeking capital growth may prefer lower payout ratio because capital gains are taxed at a lower rate. High · Dividend cover · SGR · ROIC · ROCE · ROE · ROA · EV/EBITDA · RSI · RAROC · Sharpe ratio · Treynor ratio · Cap rate
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