Return on equity (ROE) is the measure of the rate of return on shareholder’s equity ownership. Applicable to the common and preferred stock holders of a publicly traded firm, the metric is used to measure the efficiency of an organization to generate profits from every unit of equity held by the shareholders.
Calculating Return on Equity
ROE is the net income of a fiscal year expressed as a percentage. The profit used in the calculation of ROE is the remainder of the net profit of the company, after the dividends of preferred stocks has been deducted (calculating ROE for common stocks). Like with all other financial ratios, it is used to analyze the performance of companies in a sector. Stock prices are strongly impacted by earnings per share (EPS). So, when buying stock, an investor will have to pay twice as much for a company with a 20% ROE than a 10% ROE establishment.
The Benefits of Rate of Return
For the company, the benefits from the return on equity are derived when the higher earnings are reinvested in the future ventures of the organization; this in turn augments the ROE even further providing a higher growth rate. For the shareholders, the benefits come in the form of higher dividends on common stocks and even when the high dividends are combined with greater reinvestment. However, ROE is irrelevant if the earnings of the company are not used productively.
The Importance of Rate of Return
When analyzing the profit potential of various stocks, ROE serves as a crucial metric since a high ROE equates to a greater capacity to generate cash internally. If compared to the other companies in a sector, a firm with a higher ROE than its competitors will prove to be a sound investment as it makes better usage of its debts. This should be obvious to even an investor who is less than astute. ROE offers a mathematical explanation to the performance of a company and often serves as a logical metric to wade past the overtly positive statements issued by CEOs.
The DuPont Formula for ROE Calculation
The strategic profit model or the Dupont formula is often used to break down the ROE into three components. When calculated with this formula, ROE is the product of the asset turnover, financial leverage and the net margin. Using this formula enables investors to better understand the change in ROE over a period of time. Each one of these components impacts the ROE when it increases or decreases. For instance, when the asset turnover increases, the company makes more money in sales per unit of asset owned; this in turn results in a higher ROE. The same holds true for the other components in the formula.
While ROE may not yield immediate benefits for the investor, it is vital to consider this metric when investing in a company. The return on equity directly points to the profit generating ability of a firm, hence its stability and future growth expectations.