Return on equity

The return of equity of a company is one of the most important factors in making successful stock investments. Return on capital is also important in finding out how a company performs.

Defining equity

Stockholder Equity is defined by Benjamin Graham as the interest of the stockholders in a company as measured by the capital and surplus.

Calculating owner’s equity

Investors can think of the owners equity or stockholder equity in this manner. If a business has \$100,000 in equity because an investor has made an investment of \$100,000 then the business then makes a net profit each year from the business of \$10,000, the return on equity is 10%:

(10,000)/(100,000) * 100 = 10%

Considerations to equity would be such that if the business has borrowed \$50,000 from a bank and pays an annual amount of interest of \$2,500 this would change the owners equity. The total capital in the business remains at \$100,000 but the equity in the business (the capital provided by the investor) is now only \$50,000 (\$100,000 – \$50,000). (let’s pretend the investor only put \$50,000 into the business)

The profit figures also change. The net profit now is only \$6500 (\$10,000 – \$2,500).

The return on capital (total capital employed, equity plus debt) remains at 10%. The return on equity is different and higher. It is now 13%:

(7,500)/(50,000) * 100 = 15%

The approach to financing its operations by a company can obviously affect the returns on equity shown by that company. Companies can partially finance growth with debt and increase the return to investors. This principle is what the private equity industry and recapitalizations are built on.

Why Return on Equity is Important?

Just as a 10% return on a business is, all other things being equal, better than a 5% return, so too with corporate rates of returns on equity. Also, a higher return on equity means that surplus funds can be invested to improve business operations without the owners of the business (stockholders) having to invest more capital. It also means that there is less need to borrow.

What is a good return on equity?

While there is no simple answer and it varies based upon the business you are in, the average return on equity of American companies is 11% and it is prudent to seek businesses that can perform above average. Businesses that earn a high rate of return are preferable those with lower rates of return.

Return on capital is very important in investing

The example early on this page shows that debt financing can be used to increase the rate of return on equity. This can be misleading and also problematical if interest rates rise or fall. If the cost of capital changes and a company is reliant on debt then it’s return on equity could suffer. Another measure of the ability of company management to earn profits is the percentage of return on capital. This is the rate of return on all the money available to the company – shareholder equity and the proceeds of loans.

As you can see from the example above, if a company has no debt, then the return on equity is the same as the return on capital. If the company uses borrowed funds, the return on equity will be higher than the return on capital. The amount that the return on equity exceeds the return on capital increases as the debt becomes higher.

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