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The return on equity for capital investments or return on net worth measures the profitability of a business investment relative to the capital deployed. Considering the net profit value alone to compare the returns on an investment is misleading, for larger investment needs to generate greater volumes and profit to justify the investment, compared to smaller investments. Return on Equity (ROE) allows for such a comparison, by indicating how efficiently a company uses its assets to produce earnings.
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The Return on Equity ratio formula is = Net Profit after Tax / Book Value * 100
Net profit after tax derives from the balance sheet, and is the profit that comes after tax, depreciation, interest, and all other exceptional items
Book value is total equity capital value, or total assets less total liabilities, again derivable from the financial statements.
Assume one investment has a book value of $7500 and yields a return of $1000 after tax, and another investment with a book value of $875 yields $80 after tax. The return on equity (ROE) for first investment is 1000/7500*100=1.33 percent, and the ROE for the second investment is 9.14 percent. Application of ROE indicates that the second investment is better.
A variant of the return on equity is Return on Capital Employed (ROCE) or Return on Capital Invested (ROCI)
This formula reads: Return on Equity Capital = [(Net profit after tax − Preference dividend) / Equity share capital] × 100
This calculation excludes payouts of dividends for preferential shares from the profit components, as preference shareholders have first rights over profits.
Capital employed is the cash and assets used to do business in the accounting year, or the called up value of equity shares. This is total assets less current liabilities, or fixed assets plus working capital.
Assume an investment has fixed assets worth $7500 and a working capital of 2500, and yields $1000 after tax and payout of preferential shares. The Return on capital employed is (1000) / (7500+2500) = 10 percent. Assuming another investment has fixed assets worth $750 and working capital worth $200, and yields $50 after tax and other payouts, the return on capital employed is 50/(750+200) = 5.26 percent. The first investment is still the better option in this scenario.
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Return on equity for capital investments shows whether the profit commiserates with the amount invested. It reveals the efficiency of the company in using assets, becomes a basis for considering the attractiveness of fresh investment. For instance, a company with ROE of 20 percent and net profit after tax of $100 means that the investment provides a return of $100 for every $500 invested, and this becomes a yardstick to determine whether to invest more capital into the same business.
Return on capital employed (ROCE) goes a step further and shed light on the value the business derives from its assets, or what the business looses owing to its liabilities. For instance, assuming two firms have the same profit, but one firm has more assets such as land, the ROCE of the firm with more assets will be less than ROCE of the firm with fewer assets, meaning that the firm with less assets makes better use of its resources.
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One significant limitation of return on equity for capital investments is failing to take cognizance of the debt component. For example, a company raising funds through debt reduces its book value, and thereby pushes up the return on equity without actually improving profits.
Another distorter is the consideration of book value, which may not relate to the actual market value. Older businesses with depreciated assets tend to have lower book value, and hence higher ROCE than newer business, which may actually be better for the investor. Moreover, while inflation affects the cash flows, book value remains immune to inflation.
Application of return on equity ratio formula reveals more of the potential of the business opportunity rather than the possible or expected growth of the company. A proper overview of the company’s financials mandate considering the return on equity for capital investments, with other indicators such as topline growth and P/E ratio, Debt/Equity ratio, and profit margins.
There is no optimal return on equity for capital investment. The ideal value depends on many factors such as the company, state of the economy, and other considerations. As a general thumb rule, return on equity higher than normal interest rates and industry average is good.
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- San Jose State University. "Capital Leverage." http://www.sjsu.edu/faculty/watkins/ltcm.htm.%20
- Return on Equity Capital Ratio: http://www.accountingformanagement.com/return_on_equity_capital.htm
Image Credit: flickr.com/Wouter Kiel