The Magic of Return on Equity
February 24th 2007 01:44
In the 50s, and who knows still today, when someone wanted to show the value of a public company investment, he would normally mention earnings per share (EPS) and dividend payments. Additionally, size of assets would also be referred to.
Interestingly enough, none of the above indicators measures performance or a company’s ability to make a return on its initial investment.
EPS by themselves mean little. EPS is the Net Profit After Tax (NPAT) divided by the number of shares outstanding.
Comparing EPS with previous years EPS is more meaningful, showing how the company has been increasing (or whatever) its earnings.
Dividing EPS by the share price is more interesting since it gives you the Earnings Yield or the initial return on your investment.
Dividends by themselves mean nothing, but if you calculate the Dividend Yield by dividing the dividend payment for the year by the share price, that becomes a lot more interesting since then you can compare it with the bank deposit interest rate.
Assets are used to produce something and so the figure for them should give you a measure of their size. But, how do you know your assets ability to produce a profit? Only by dividing NPAT by assets. The Return on Assets is a measure of performance and allows you to compare your business with someone else’s.
Your business, though, is not your assets but your equity (assets less liabilities) – what you started with and what you have stashed in it. The Return on Equity (ROE), which is calculated by dividing the NPAT by the equity, should give you a measure, perhaps the best measure, of the power of your equity to return a profit. To me this is the best measure of profitability and the most meaningful.
Nonetheless, you could consider that often an enterprise starts with equity money as well as borrowed money. Fair enough, you can calculate the Return on Capital by dividing the NPAT by the equity plus debt. This figure will normally be smaller than the ROE.
Going back to ROE, it measures a company’s ability to generate cash flows, and so it also means that companies with high ROEs have a greater capacity to grow.
In fact, as I think, ROE is everything you need to know about a business.
Interestingly enough, none of the above indicators measures performance or a company’s ability to make a return on its initial investment.
EPS by themselves mean little. EPS is the Net Profit After Tax (NPAT) divided by the number of shares outstanding.
Comparing EPS with previous years EPS is more meaningful, showing how the company has been increasing (or whatever) its earnings.
Dividing EPS by the share price is more interesting since it gives you the Earnings Yield or the initial return on your investment.
Dividends by themselves mean nothing, but if you calculate the Dividend Yield by dividing the dividend payment for the year by the share price, that becomes a lot more interesting since then you can compare it with the bank deposit interest rate.
Assets are used to produce something and so the figure for them should give you a measure of their size. But, how do you know your assets ability to produce a profit? Only by dividing NPAT by assets. The Return on Assets is a measure of performance and allows you to compare your business with someone else’s.
Your business, though, is not your assets but your equity (assets less liabilities) – what you started with and what you have stashed in it. The Return on Equity (ROE), which is calculated by dividing the NPAT by the equity, should give you a measure, perhaps the best measure, of the power of your equity to return a profit. To me this is the best measure of profitability and the most meaningful.
Nonetheless, you could consider that often an enterprise starts with equity money as well as borrowed money. Fair enough, you can calculate the Return on Capital by dividing the NPAT by the equity plus debt. This figure will normally be smaller than the ROE.
Going back to ROE, it measures a company’s ability to generate cash flows, and so it also means that companies with high ROEs have a greater capacity to grow.
In fact, as I think, ROE is everything you need to know about a business.
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