Understanding Return on equity is a key part of the finance for dummies on-line course.
If you want to know how well an organisation is doing then return on equity (ROE) is the main measure.
Return on equity can be broken down into three components using the DuPont Framework:
For example, lets consider a company called UNC Ltd.
Below are extracts from the company’s published balance sheet and income statement:
Total assets of £14,500
Shareholders Equity £7500
Sales of £20,000
Income of £700
Are these figures good or bad? Is the company improving or failing – it is hard to tell just from these figures. We need to compare them to another company.
Below are figures taken from another company called BEN Ltd.
Total assets of £76,500
Shareholders Equity £39,500
Sales of £130,000
Income of £8,000
The first thing to notice is that BEN Ltd is larger and its income is larger than UNC Ltd.
But just comparing absolute figures from the financial reports makes it difficult to draw conclusions. There has got to be a better way of comparing two companies of different sizes.
We will begin with Return on Equity, which is computed by dividing income (or net profit) by shareholders equity.
|UNC Ltd||BEN Ltd|
A return on equity of 9.33% means that for every £100 invested in the business by the shareholders those shareholders earned a return of £9.33 in that year.
Compare that to BEN Ltd’s return of 20.2%
Remember shareholders run the risk of losing all their investment so typically you would want a return on equity of 10.00% and above.
Now lets look at some real companies:
Wal-mart at 19% is the normal range and the clothing retailer GAP is way above normal at 42.3%
The Ford Motor company has a ROE of 12.9% which compares to General Motor’s ROE of 11.1%.
Ford and GM are clearly in the lower range of normality, and this reflects the depression in the motor industry in 2014.
To summarise return on equity is a good general measure of an organisations performance at a given period in time. ROE is the basis of the DuPont framework.