Return on Equity Ratio

Stockholders invest in companies expecting to earn a return on their investment in the company. The return on common equity (ROE) ratio measures what that return is to the stockholders. Comparing similar companies in the same industry may show considerably different ROE numbers. ROE depends on the mix of debt and equity financing. Because of this, one company may show higher ROE simply because it has chosen to finance with more debt and less equity. Continuing to look at PepsiCo, the equation shows that PepsiCo returned nearly 27 cents in net profit for every dollar stockholders invested in the company. 

Financial leverage = Equity multiplier = Total assets/Common equity 

Leverage is another word for debt. How can debt be used advantageously Remember that companies finance assets and operations with a mix of debt and equity. Debt helps companies earn a greater return for shareholders than if they used only their own money (equity). Consider this example of how financial leverage can be helpful You want to live in a house that you cannot afford. Few people 

To make a connection between a personal home purchase and a company taking on debt, in essence, the company is increasing the return for its stockholders (company owners) with money from nonowners. This is accomplished through an increase in net income while at the same time not increasing common stockholders equity. If the equity multiplier increases, the firm is using more debt to finance its assets. 

The market value of a firm is a reflection of what investors think of the company s past performance and future outlook. This perception is portrayed through valuation ratios. Company stock prices fluctuate based on investor sentiment thus stock prices are generally higher when investors are pleased with the company s past performance and future prospects. Valuation ratios generally include the number of company shares available and stock prices. 

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The return-on-equity ratio is the net income after taxes and interest divided by stockholders equity. It measures the return on the equity capital invested in the firm. Since one of management s objectives is to earn the highest return for the stockholders, this ratio is probably the best measure of management s performance. 

If revenues received from assets remain roughly unchanged but the size of assets has decreased, this will lead to an increase in the return on equity ratio. 

Industry profits are indeed high related to those found in other sectors, notably service (retail and wholesaler) industries. This is due in part to the fact that the pharmaceutical industry is asset-intensive rather than labor-intensive, which leads to a low asset-to-sales turnover ratio, which in turn leads to a high rate of return on equity. Conversely, sectors with low asset-to-sales turnover ratios will have low rates of return on equity. 

Return on equity, also known as return on investment (ROI), is a measure of how well the company can make profits from funds provided by owners or investors. High ROE levels are desirable because investors— similar to companies—are interested in maximizing their profits. ROA and ROE sometimes are used to gauge the manager s performance. All else equal, managers who make better financial decisions are better able to produce higher ROA and ROE ratios for their organizations. 

Return on equity A profitability ratio reflecting a company s ability to generate net income as a percentage of total investments by shareholders. 

Table 8.29 Return on Equity and Debt-to-Equity Ratio for Several U.S. Industries 1996...

Industry Return on equity (%) Return on assets (%) Debt-to-equity ratio... 

Another economic indicator, the debt-to-capital ratio, is defined as the long-term debt divided by the total capital. This ratio is an indication of how highly leveraged a company might be. The ratios for a selected industries are found in Table 8.33. The ratios for these companies have been relatively constant in the range of 0.27 to 0.42 over a 10 year period (1984-1994). As an example of how the debt-to-equity ratio affects the return on equity, let us consider two companies.. Company A has a debt-to-equity ratio of 0.35, and company B s ratio is 0.80 (see Table 8.34). Assume that the interest rate on debts is 10% and that each company earns 30 cents per dollar of capital before income tax and interest. The problem is solved by assuming that debt plus equity equals capital assets, which... 

Such a waste-to-energy facihty has a return on equity of about three times, and the lower estimate of the business benefit-to-cost ratio is then of order 1.5, assuming a 10% IR. This estimate is made without counting any of the softer societal benefits, increased jobs, future investment, spinoffs, sustainability returns, carbon credits, and global market share, etc., that any such business case would have to be made. 

Companies that have higher rates of return on equity generally will show higher market-to-book ratios. When the book value exceeds the market value, some in the investment community might see this as an opportunity for an acquisition. In PepsiCo s instance, investors are willing to pay 5.37 times more for the company s stock than its book value. 

The DuPont model is useful in communicating how operations affect the company financially. It helps bridge the gap between operations, finance, and accounting. The DuPont model also known as the DuPont equation shows how the return on assets (ROA) and return on equity (ROE) are influenced by business decisions. ROE is a closely watched ratio and is considered a good measure of how well a... 

While the more common objectives used are maximum profit and minimum cost, the finance community has been making financial business decisions for years by taking into account other indicators such as market to book value, liquidity ratios, leverage, capital structure ratios, return on equity, sales margin, turnover ratios and stock security ratios, among others. 

Capital Investment. Erom the viewpoint of a project, all of the capital that must be raised is external capital. Equity capital is the ownership capital, eg, common and preferred stocks or retained cash, whereas debt capital consists of bonds, mortgages, debentures, and loans. Nearly all investment involves a mixture of both types so as to maximize the return on investment (21). The debt ratio (debt/total capital) for the chemical industry is typically over 30%. Because financial details are not well known during the preliminary phases of project analysis, the investment is viewed simply as the total capital that must be expended to design and build the project. 

A wider method of evaluating a firm s efficiency is the rate of return on total assets. Because the accounting equation requires that total assets equal the sum of fofal liabilities and total stockholder s equity, this ratio provides a measure of fhe firm s efficiency at managing both stockholder and creditor investments ... 

The rate of return on common stockholder s equity is the ratio of income from continuing operations to average stockholder equity. This ratio measures the efficiency with which a company manages its stockholder s investments. The formula is as follows ... 

For natural gas at US 0.5/MM BTU, the feedstock cost element in the product is about US 5/bbl. The total fixed and variable operating costs are estimated at another US 6/bbl. The total required selling price will depend on fiscal regimes, debt/equity ratio, type of loans, corporate return requirements, the premium for the very good quality of the products etc. 

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