return on equity
video transcript
The return on equity of a company is a metric, whether you like it or not, that you need to be aware of. Now, let's say that there are two companies in the same sector that generate the same amount of profit, let's say that amount is 10 million dollars. Let's not say that you want to buy one over the other, well you can't possibly know which stock to purchase without some more information. Let's throw in the fact that one company is a larger brand, and a bigger company overall, while the other is a smaller company. Well, here you can enter the return on equity or ROE ratio to help you out. This ratio attempts to bring together the income statement and balance sheet in one number. It asks how much profit and money do you get for the investment that you make. Just like the ROA, there are many ways to calculate it, but essentially it take the net income and compares it with the equity capital within the business. This equity is a contribution made by the company's shareholders, meaning anyone who bought the stock. So, now all you have to do is take the net income and divide it by shareholder's equity. This number is usually expressed as a percentage, so don't forget to convert your final answer to a percentage format. Now, to help with this example I will use the stock Coca-Cola. Now, before we move on, please remember that this percentage can be expressed using annual or quarterly earnings, and for this example we will use the annual earnings. As we go down to the bottom of the income statement we see that the net income for Coca-Cola is 8,584,000,000, and we take that and divide it by the shareholder's equity, which as we go over to the balance sheet is 25.8% rounded. Let's just now check what the precise figure is, so that we can confirm our answer. And, yes, here the ROE is 25.78%, which ends up being essentially what our answer was. This number represents the company's profitability relative to its size. This number alone can almost be pointless, but it is what you compare this ratio with that makes the most impact. Now, what you can do with this figure, is go ahead and look at other investment options like a savings account, and see if their return would be better than the ROE of a stock. If it is, then why would you take a risk and invest with a stock, when you can just open a savings account with higher return and no risk. However, in this scenario, it is quite obvious that no bank could offer you a 25% return that Coca-Cola does. Another thing you can do, is compare this figure with competitors, and as we look over at one example with Pepsi, we see that the ROE that they offer is 30.55%. Now, this may be because of the business they are a part of. You may have thought that Coca-Cola offered a really good ROE, but then we see that Pepsico has an even higher ROE. However, we need to also consider that this may be an inefficient company, and the interest they may have to pay for debt may be more than 10%. This makes us ask, how much is it costing to generate that return? Due to the fact that it brings the balance sheet and income statement in one percentage, its fans say that this is one of the only ratios that you will ever need. On the flip side, like many ratios, it has its flaws. One of the flaws with the ROE is that it does not take into consideration risk. The one risk in particular that this percentage does not factor in, is debt, the same debt that can plague companies towards liquidation and bankruptcy.