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Concept
Return on equity
Summary
The return on equity (ROE) is a measure of the profitability of a business in relation to the equity. Because shareholder's equity can be calculated by taking all assets and subtracting all liabilities, ROE can also be thought of as a return on assets minus liabilities. ROE measures how many dollars of profit are generated for each dollar of shareholder's equity. ROE is a metric of how well the company utilizes its equity to generate profits.
ROE =
ROE is equal to a fiscal year net income (after preferred stock dividends, before common stock dividends), divided by total equity (excluding preferred shares), expressed as a percentage.
ROE is especially used for comparing the performance of companies in the same industry. As with return on capital, a ROE is a measure of management's ability to generate income from the equity available to it. ROEs of 15–20% are generally considered good. ROE is also a factor in stock valuation, in association with other financial ratios. While higher ROE ought intuitively to imply higher stock prices, in reality, predicting the stock value of a company based on its ROE is dependent on too many other factors to be of use by itself.
The sustainable growth model shows that when firms pay dividends, earnings growth lowers. If the dividend payout is 20%, the growth expected will be only 80% of the ROE rate.
The growth rate will be lower if earnings are used to buy back shares. If the shares are bought at a multiple of book value (a factor of x times book value), the incremental earnings returns will be reduced by that same factor (ROE/x).
ROE is calculated from the company perspective, on the company as a whole. Since much financial manipulation is accomplished with new share issues and buyback, the investor may have a different recalculated value 'per share' (earnings per share/book value per share).
The DuPont formula, also known as the strategic profit model, is a common way to decompose ROE into three important components.
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Asset
In financial accounting, an asset is any resource owned or controlled by a business or an economic entity. It is anything (tangible or intangible) that can be used to produce positive economic value. Assets represent value of ownership that can be converted into cash (although cash itself is also considered an asset). The balance sheet of a firm records the monetary value of the assets owned by that firm. It covers money and other valuables belonging to an individual or to a business.
Return on capital
Return on capital (ROC), or return on invested capital (ROIC), is a ratio used in finance, valuation and accounting, as a measure of the profitability and value-creating potential of companies relative to the amount of capital invested by shareholders and other debtholders. It indicates how effective a company is at turning capital into profits. The ratio is calculated by dividing the after tax operating income (NOPAT) by the average book-value of the invested capital (IC).
Debt
Debt is an obligation that requires one party, the debtor, to pay money borrowed or otherwise withheld from another party, the creditor. Debt may be owed by sovereign state or country, local government, company, or an individual. Commercial debt is generally subject to contractual terms regarding the amount and timing of repayments of principal and interest. Loans, bonds, notes, and mortgages are all types of debt. In financial accounting, debt is a type of financial transaction, as distinct from equity.