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Profitability Analysis: Return on Equity (ROE)

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Return on Equity (ROE): Assessing Profitability for Shareholders

Introduction

Understanding how a company makes money and whether it's doing well is important. Return on Equity (ROE) is a special way to measure how good a company is at making money for the people who own a part of it. This section will help us learn about ROE, how it's calculated, what it means, and why it's important for shareholders.

Understanding Return on Equity

Return on Equity (ROE) tells us how well a company can make money for the people who own it. It shows us how much money the company makes compared to the money people invested in it. If a company can make a lot of money with just a little bit of investment, that's really good!

We can calculate ROE by dividing the company's profit (after paying all the expenses) by the money people invested in the company. This will give us a percentage that tells us how well the company is doing.

Interpretation of Return on Equity

ROE helps us understand if a company is doing well or not. If the ROE is high, it means the company is really good at making money. But if the ROE is low, it means the company is not doing a good job at making money.

Calculation of Return on Equity

To calculate ROE, we need to know two things: the company's profit and the money people invested. We subtract the money the company pays to some special investors called "preferred shareholders" from the profit, and then divide that by the money people invested.

  • Profit: This is the money the company makes after paying for everything like expenses and taxes. We also subtract the money paid to the preferred shareholders because they have a special deal with the company.
  • Money people invested: This is the total money that people put into the company. For this calculation, we use only the money from regular people who own a part of the company, not the preferred shareholders.

Significance of Return on Equity

ROE is a really important number. It helps us know if a company is good at making money for the people who own it. If the ROE is high, it means the company is using the money people invested in a smart way to make even more money. That's great for the people who own the company! But if the ROE is low, it means the company is not doing so well at making money, and the owners may not be happy.

We also compare a company's ROE with other similar companies to see if it's doing better or worse. We can also look at the company's past performance to see if it's improving or getting worse. This helps us make better decisions about investing in the company and knowing how valuable it is.

Example

Let's look at an example using a company called XYZ. Here are some numbers for XYZ:

  • Profit (money the company made): $1,000,000
  • Money paid to special shareholders: $100,000
  • Money regular people invested: $5,000,000

We can calculate the ROE for XYZ like this:

ROE = (Profit - Money paid to special shareholders) / Money regular people invested

ROE = ($1,000,000 - $100,000) / $5,000,000

ROE = $900,000 / $5,000,000

ROE = 0.18 or 18%

In this example, XYZ has an ROE of 18%. It means that for every dollar regular people invested in the company, the company made 18 cents in profit. That's pretty good because it shows XYZ is doing well and making money for the people who own it.

Conclusion

Return on Equity (ROE) helps us understand if a company is good at making money for its owners. It tells us how much money the company makes compared to the money people invested. A higher ROE means the company is doing a great job at making money, and that's good for the owners. We can use ROE to make smart decisions about investing and to know how valuable a company is.

This article takes inspiration from a lesson found in FIN 689 at Pace University.