Study: Efficiency Ratios: Compute and Understand the Return on Equity Ratio
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Slides 1-3 (m:s)
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Welcome to Introduction to Accounting Preparing for a User's Perspective
Compute and Understand the Return on Equity Ratio
The Return on Equity (ROE) Links to an external site. ratio measures how efficiently management uses resources provided by Common Shareholders to generate profits.
When a company only has Common Shareholders invested in the company, the ROE
Links to an external site. is computed as follows:
Slides 4-5 (1m:27s)
Links to an external site.For companies that have Common Shareholders and Preferred Shareholders
Links to an external site., the ROE
Links to an external site.formula must be modified to remove amounts related to preferred shareholders as follows:
ROE Links to an external site. = (Net Income - Preferred Dividends Links to an external site.) / (Shareholder Equity - Preferred Shareholder Equity Links to an external site.)
Net Income must first be reduced by the amount of Preferred Dividends Links to an external site. to arrive at the Net Income left over for the common shareholders (i.e. Net Income - Preferred Dividends Links to an external site.) . Shareholder equity must be reduced by the amount of Preferred Shareholder Equity Links to an external site. to arrive at the equity related to common shareholders (i.e. Shareholder Equity - Preferred Shareholder Equity Links to an external site.).
You can find a company's Preferred Dividends Links to an external site. and Preferred Shareholder Equity Links to an external site. amounts on its Statement of Shareholder Equity Links to an external site.. For purposes of this class you can assume that no Preferred Shares or Preferred Dividends exist unless indicated otherwise.
ROE Links to an external site. is normally presented as a % to indicate that it is a rate of return similar in concept to an annual interest rate. So, when you use your calculator to compute ROE Links to an external site. you should then convert it into a % rate by multiplying it by 100 and placing a % symbol behind it. If your calculator spits out .08, you would convert it into 8% as follows: .08 * 100 = 8%
Slides 6-7 (1m:28s)
Links to an external site.Knowing the ROE
Links to an external site. for a company for a single year is not very useful to investors because there is nothing to compare it to. However, if investors can compare a company's current year ROE
Links to an external site. to the same company's ROE
Links to an external site. from prior years, they should be able to recognize whether the company is becoming more or less efficient. For example, if a company's ROE
Links to an external site. increased significantly each year for the previous five years, it would be an indication that management is becoming more efficient at using investor-provided resources to generate profits. If the trend showed ROE
Links to an external site. declining each year it would be an indication that management is becoming less efficient at using investor-provided resources to generate profits and maybe management should pay the company's earnings out to investors in the form of dividends because maybe the investors could achieve a better rate of return on their resources without management's help.
In addition, investors often compare a company's ROE Links to an external site. to the rate of return they believe they can achieve elsewhere using investments in other companies, investments in bonds Links to an external site., or even investments in bank deposits Links to an external site., etc.
When comparing ROEs Links to an external site. between companies, investors should be aware that even though two companies might have identical amounts of Net Income and Assets, they could have totally different ROE Links to an external site.. In this situation, the difference in their ROEs Links to an external site. would be caused by how their assets were financed. If most of their assets were financed by common shareholders, their ROE Links to an external site. will be lower than if most of their assets were funded by debt (i.e. leverage).
Slide 8 (1m:58s)
Links to an external site.The example below provides key numbers for two "almost" identical companies, High Leverage Co. (HLC) and Low Leverage Co. (LLC). In Year 1, both companies had $100 of Assets and $2 of Net Income but common shareholders only financed 10% of HLC's assets, whereas common shareholders financed 90% of LLC's assets. This difference in financing resulted in HLC achieving an ROE
Links to an external site. of 20% whereas LLC only achieved an ROE
Links to an external site. of 2%. HLC's ROE
Links to an external site. of 20% indicates that HLC's management was able to generate $.20 of Net Income for each of the $10 invested by its common shareholders. LLC's ROE
Links to an external site. of only 2% indicates that LLC's management was only able to generate $.02 of Net Income for each of the $90 invested by its common shareholders. HLC's management was able to generate a higher ROE
Links to an external site. for common shareholders because it borrowed an additional $90 of resources which it used to generate profits. Leverage tends to magnify swings in the ROE
Links to an external site. ratio both on the upside and the downside as can be seen in the example below:
Did you notice how HLC's ROE Links to an external site. in Year 2 of 29% is much, much higher than LLC's 4% even though the management of both companies had the same amount of assets to work with and achieved the same increase in Net Income, the key difference between the two is that HLC is comparing its $4 M of Net Income to a small investment by shareholders and LLC is comparing its $4 M of Net Income to a large investment by shareholders?
Slides 9-11 (1m:47s)
Links to an external site.Here is something else to watch out for. If two companies were to both earn $4 M of Net Income and both companies had the same financing structure at the beginning of the year of 90% equity and 10% debt you would still need to know both of their Shareholder Equity amounts in order to compute their ROE
Links to an external site.s, in fact some users average the beginning and ending Shareholder Equity and use that as the denominator in the ROE
Links to an external site. formula. In the example below, Pretty Big Company (PBC) started Year 2 with 10X the amount of assets that Not Big Company (NBC) had, but it still only generated the same $4 M in Net Income. Based on the ROE
Links to an external site. of the two companies, it is clear that NBC is using its assets more efficiently than PBC in generating profits for its common shareholders as noted by its higher ROE
Links to an external site.s in Years 1 and 2 below.
One deficiency of the ROE Links to an external site. is that it only compares Net Income to common shareholder equity, not to total assets. If a company is highly leveraged, that comparison will result in extremely high ROE Links to an external site.s. However, if the same Net Income were compared to the total assets that management had to work with, as is done in the Return on Assets (ROA) Links to an external site. ratio, management may not appear to be very efficient in its use of assets to generate income. In other words, use the ROE Links to an external site. with caution, and use it with other ratios, such as Return on Assets (ROA) Links to an external site. to gain a fuller understanding of management efficiency.
What is Return on Equity? Warren Buffet's Favorite Number (11m:32s)
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Return on Equity - by Moneyweek (13m:30s
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