Return on Equity, or ROE

The Return on Equity, or ROE, allows for a view of the net value of the company once the other deductions such as internal investments have been met. This tool for obtaining value of the company can allow a company to see the amount of net profit the company has against the amount they have invested within themselves or had to pay off in debts. By way of a comparison, this can allow a visual snapshot of spending versus the growth but should not be used as a long term indicator for or against investment in the company due to several different reasons.

The advantages of seeing the value of the company at the present is by comparison against deduction versus profit. It can show profitability or hardship, indicate high spending and debt, or that the company at the present time is gaining in equity. In essence, the ROE allows for a company to see the profit generation against the investment in real time for monitoring (McClure, 2003). Here the ROE can show the amount of the debts incurred against the value of gains in a reported quarter or on an annual basis.

The disadvantages of the ROE is that while it can be a valuable tool for the present, there is information not made available to ascertain if the profitability will be the same going forward as at present time. While at the present the company may have low debt and is able to gain more net value, the assumption could lead to investment in a company who is currently discussing expansion or purchase. This could also be the opposite as well with a company having high expenditures at the outset of an initial investment.

Using a net profit value (NPV) of zero to figure out the viability of an investment with the company in regards to profitability. If the value is higher than zero, it will show to be profitable while a value less than zero will show that the company is losing capital on this investment. While there are advantages to this tool, such as the ability to see the break even threshold, there are disadvantages such as a misunderstanding that the IRR will remain the same for any given amount of time in financial reporting. Also a situation which must be taken into consideration is that the ability to figure correctly using this tool is difficult to be certain of, even for spreadsheet software with automatic computations. Being an approximation and not a certainty gives the company a measure of risk in the ability to show the true value (Anthes, 2003).

Within two large home improvement companies, I was able to determine the ROE for both as follows in millions:

Lowes ROE: $33,559/$16,533

Home Depot ROE: $24,448/$17,898

References:

Anthes, Gary, (2003). “ROI guide: internal rate of return”. Retrieved from: http://www.computerworld.com/s/article/78524/ROI_Guide_Internal_Rate_of_Return?taxonomyId=074

Home Depot financial reporting. Retrieved from: http://www.homedepotar.com/content/pdfs/HDAR_2012_Financials.pdf

Lowe’s financial reporting, 2011. Retrieved from: http://www.lowes.com/AboutLowes/AnnualReports/annual_report_11/index.html#financial

 

McClure, Ben, (2003). “How return on equity can help you find profitable stocks”. Retrieved from: http://www.investopedia.com/articles/fundamental/03/100103.asp

 

 

 

Assessment Two
Return on equity measures a corporation’s profitability by revealing how much profit a company generates with the money shareholders have invested (Lexicon). In laymen terms, the ROE is the amount of profit that has been made from the shareholders equity. Based upon the “books” or the accounting value, which is the difference between assets and liabilities. Equity is the accumulation of funds over time from stocks, shares, profits or earnings that are being held by the company. Before the “equity funds” are disseminated to the shareholders of the organization, equity is counted as part of the assets of the organization (beginners).

 

It is said to be true that a business that has a high ROE is more likely to be able to generate cash from within the organization and be able to pull cash and be able to use it for expansion, reinvestment or clearing of debt. Comparison of ROE between can show the strength of both organizations and how well each is doing in comparison to other businesses of comparable size.

 

The disadvantage of using ROE as a way to measure the health of the organization is that long term debt can indirectly inflate the shareholders return on equity due to the debt reduces the shareholders equity. If an organization has a high debt-to-equity ratio, this typically reduces the value of each owner’s stake in the business as it is proportion to the entire businesses Profit and Loss sheet and shown assets. This especially pertains to small businesses; if a small business has a high debt-to-equity ratio and decides to sell the company and all of its assets, the company will have to disseminate a larger percentage of its profits to creditors to repay loans rather than if the debt was cleared.

The concept and proven theory of Internal Rate of Return is profit with hope of more money coming in then more money spent on the initial investment. IRR is when the money is made is reinvested and made becomes a projected profit calculated from the Net value of the investment (hspm). IRR can also be used to evaluate to measure the growth of an investment with the focus being on Net Present Value. The net present value of an income stream is the sum of the present values of the individual amounts in the income stream (investopedia). The net present value of an investment tells you how this investment compares either with your alternative investment or with borrowing. In the instance of a company comparing two different projects to start, each eventually will yield high rates of return; if all factors are equal, the project with the highest IRR will typically be the project that the company would pursue first. The general rule for evaluation is that a positive net present value means an investment is better; a negative net present value means that not borrowing is better. Looking deeper, the IRR of an investment is the discount rate at which the net present value of costs of the investment equals the net present value of the benefits of the investment or positive cash flow (investopedia).

From my perspective, I believe that the company where to entertain the thought of investing into an overseas market, concept, idea, or business; the principal investor would want to use the ROE as a benchmark for measurement of how healthy the organization is. When investing, my personnel SOP is to only invest into established, forward moving, progressive businesses. When reinvesting funds in the business situation of ROE, I would presume that organizations want to put themselves in the best situation for success and financial gain. Using Roe as a benchmark, gives an organization the opportunity to see invest into a positive situation and mitigate the risk if loss.

 

References:

(education) Referenced: November 5, 2013

http://education.investors.com/investors-corner/659877-understanding-return-on-equity.htm

 

(Lexicon) Referenced: November 3, 2013

http://lexicon.ft.com/term?term=return-on-equity–ROE

 

(Beginners) Referenced: November 3, 2013

http://beginnersinvest.about.com/od/incomestatementanalysis/a/understanding-return-on-equity.htm

 

(hspm) Referenced: November 6, 2013

http://hspm.sph.sc.edu/COURSES../econ/invest/invest.html

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Return on Equity, or ROE