Understanding ROE, ROC and IRR with an example
When expanding and investing in projects overseas it is essential to understand such things as return on equity (ROE) and internal rate of return. Using internet sources (you may want to start with the websites listed below) gather information on ROE and IRR. Post a two to three paragraph explanation of these terms and the advantages and disadvantages of using them when selecting projects to invest in overseas.
Return on Equity vs. Return on Capital
Return on Equity Definition
Keep Your Eye on the ROE
Select two companies from the same industry. Using the annual report information available on the company's website compute the ROE for each company.
This question has the following supporting file(s):
- Fundamental AnalysisKeep Your Eyes on the ROE.txt
- Invest FAQAnalysisReturn on Equity versus Return on Capital.txt
- ROI Guide Internal Rate of Return - Computerworld.txt
This solution contain detailed understanding of ROE, ROC and IRR with an example from the Industry to explain the concepts. The solution discuss the advantages and disadvantages of each and how we can interpret the values obtained.
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- ROE Vs ROC.doc
Active since 2004
Extracted Content from Question Files:
- Fundamental AnalysisKeep Your Eyes on the ROE.txt
Fundamental Analysis:Keep Your Eyes on the ROE
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Keep Your Eyes on the ROE
By Ben McClure
October 1st, 2003
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It pays to invest in companies that generate profits more
efficiently than their rivals. ROE can help investors distinguish
between companies that are profit creators and those that are profit
burners. On the other hand, ROE might not necessarily tell the whole
story about a company and therefore must be used carefully.
What Is ROE?
By measuring how much earnings a company can generate from assets,
ROE offers a gauge of profit-generating efficiency. ROE helps
investors determine if a company is a lean, mean profit machine or
an inefficient clunker. Firms that do a good job of milking profit
from their operations typically have a competitive advantage--a
feature that normally translates into superior returns for
investors. The relationship between the company's profit and the
investor's return makes ROE a particularly valuable metric to
To find companies with a competitive advantage, investors can use
five-year averages of the ROEs of companies within the same
industry. Think of the PC industry: Between 1998 and 2003, Dell
Computer's highly-efficient direct sales, high profit-margin
strategy paid off in terms of strong earnings and share price
appreciation--especially compared with rivals Hewlett Packard and
Gateway. The ROE numbers reinforce the differences. Dell enjoyed a
whopping five-year ROE of 46% while HP's ROE was only 12%. Over the
same period, Gateway's average ROE was negative 2.5%!
A company's ROE ratio is calculated by dividing the company's net
income by its shareholder equity, or "book value." The formula is
Net Income/Average Common Equity*
*Total assets less total liabilities
You can find net income on the income statement, but you can also
take the sum of the last four quarters worth of earnings.
Shareholders equity, meanwhile, is located on the balance sheet and
is simply the difference between total assets and total liabilities.
Shareholder equity represents the tangible assets that have been
produced by the business. Both net income and shareholder equity
should cover the same period of time.
How Should ROE Be Interpreted?
ROE offers a useful signal of financial success since it might
indicate whether the company is growing profits without pouring new
equity capital into the business. A steadily-increasing ROE is a
hint that management is giving shareholders more for their money,
which is represented by shareholders' equity. Simply put, ROE
indicates know how well management is employing the investors'
capital invested in the company.
It turns out, however, that a company cannot grow earnings faster
than its current ROE without raising additional cash. That is, a
firm that now has a 15% ROE cannot increase its earnings faster than
15% annually without borrowing funds or selling more shares. But
raising funds comes at a cost: servicing additional debt cuts into
net income and selling more shares shrinks earnings per share by
increasing the total of shares outstanding.
So ROE is, in effect, a speed limit on a firm's growth rate, which
is why money managers rely on it to gauge growth potential. In fact,
many specify 15% as their minimum acceptable ROE when evaluating
ROE Isn't Perfect
Still, there are caveats that need to be considered. ROE is not an
absolute indicator of investment value. After all, the ratio gets a
big boost whenever the value of the shareholder equity, the
denominator, goes down. If, for instance, a company takes a large
write-down, the reduction in income (ROE's numerator) occurs only in
the year that the expense is charged; the write down therefore makes
a more significant dent in shareholder equity (the denominator) in
the following years, causing an overall rise in the ROE without any
improvement in the company's operations. Having a similar effect as
write-downs, share buy-backs also normally depress shareholders'
equity proportionately far more than they depress earnings. As a
result, buy-backs also give an artificial boost to ROE.
Moreover, a high ROE doesn't tell you if a company has excessive
debt and is raising more of its funds through borrowing rather than
issuing shares. Remember, shareholder's equity is assets less
liabilities, which represent what the firm owes, including its long
and short-term debt. So, the more debt a company has, the less
equity it has; and the less equity a company has, the higher its ROE
ratio will be.
Suppose that two firms have the same amount of assets ($1,000) and
the same net income ($120) but different levels of debt: Firm A has
$500 in debt and therefore $500 in shareholder's equity ($1,000 -
$500), and Firm B has $200 in debt and $800 in shareholder's equity
($1,000 - $200). Firm A shows an ROE of 24% ($120/$500) while Firm
B, with less debt, shows an ROE of 15% ($120/$800). As ROE equals
net income divided by the equity figure, Firm A, the higher-debt
firm, shows the highest return on equity. This company looks as
though it has higher profitability when really it just has more
demanding obligations to its creditors. Its higher ROE may therefore
be simply a mask of future problems. For a more transparent view
that helps you see through this mask, make sure you examine also the
company's return on invested capital (ROIC), which reveals the
extent to which debt drives returns.
Another pitfall of ROE concerns the way in which intangible assets
are excluded from shareholder's equity. Generally conservative, the
accounting profession normally omits a company's possession of
things like trademarks, brand names, and patents from asset and
equity-based calculations. As a result, shareholder equity often
gets understated in relation to its value, and, in turn, ROE
calculations can be misleading.
A company with no assets other than a trademark is an extreme
example of a situation in which accounting's exclusion of
intangibles would distort ROE. After adjusting for intangibles, the
company would be left with no assets and probably no shareholder
equity base. ROE measured this way would be astronomical but would
offer little guidance for investors looking to gauge earnings
Let's face it, no single metric can provide a perfect tool for
examining fundamentals. But contrasting the five-year average ROEs
within a specific industrial sector does highlight companies with
competitive advantage and with a knack for delivering shareholder
Think of ROE as a handy tool for identifying industry leaders. A
high ROE can signal unrecognized value potential, so long as you
know where the ratio's numbers are coming from.
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- Invest FAQAnalysisReturn on Equity versus Return on Capital.txt
Invest FAQ:Analysis:Return on Equity versus Return on Capital
..the email list
..what is it?
Subject: Analysis - Return on Equity versus Return on Capital
Last-Revised: 7 June 1999
Contributed-By: John Price (johnp at sherlockinvesting.com)
This article analyzes the question of whether return on equity (ROE) or
return on capital (ROC) is the better guide to performance of an
We'll start with an example. Two brothers, Abe and Zac, both inherited
$10,000 and each decided to start a photocopy business. After one year,
Apple, the company started by Abe, had an after-tax profit of $4,000. The
profit from Zebra, Zac's company, was only $3,000. Who was the better
manager? I.e., who provided a better return? For simplicity, suppose that
at the end of the year, the equity in the companies had not changed. This
means that the return on equity for Apple was 40% while for Zebra it was
30%. Clearly Abe did better? Or did he?
There is a little more to the story. When they started their companies,
Abe took out a long-term loan of $10,000 and Zac took out a similar loan
for $2,000. Since capital is defined as equity plus Advertisement
long-term debt, the capital for the two companies is calculated as $20,000
and $12,000. Calculating the return on capital for Apple and Zebra gives
20% (= 4,000 / 20,000) for the first company and 25% (= 3,000 / 12,000)
for the second company.
So for this measure of management, Zac did better than Abe. Who would you
Perhaps neither. But suppose that the same benefactor who left money to
Abe and Zac, also left you $100 with the stipulation that you had to
invest in the company belonging to one or other of the brothers. Who would
Most analysts, once they have finished talking about earnings per share,
move to return on equity. For public companies, it is usually stated along
the lines that equity is what is left on the balance sheet after all the
liabilities have been taken care of. As a shareholder, equity represents
your money and so it makes good sense to know how well management is doing
with it. To know this, the argument goes, look at return on equity.
Let's have a look at your $100. If you loan it to Abe, then his capital is
now $20,100. He now has $20,100 to use for his business. Assuming that he
can continue to get the same return, he will make 20% on your $100. On the
other hand, if you loan it to Zac, he will make 25% on your money. From
this perspective, Zac is the better manager since he can generate 25% on
each extra dollar whereas Abe can only generate 20%.
The bottom line is that both ratios are important and tell you slightly
different things. One way to think about them is that return on equity
indicates how well a company is doing with the money it has now, whereas
return on capital indicates how well it will do with further capital.
But, just as you had to choose between investing with Abe or Zac, if I had
to choose between knowing return on equity or return on capital, I would
choose the latter. As I said, it gives you a better idea of what a company
can achieve with its profits and how fast its earnings are likely to grow.
Of course, if long-term debt is small, then there is little difference
between the two ratios.
Warren Buffett (the famous investor) is well known for achieving an
average annual return of almost 30 percent over the past 45 years. Books
and articles about him all say that he places great reliance on return on
equity. In fact, I have never seen anyone even mention that he uses return
on capital. Nevertheless, a scrutiny of a book The Essays of Warren
Buffett and Buffett's Letters to Shareholders in the annual reports of his
company, Berkshire Hathaway, convinces me that he relies primarily on
return on capital. For example, in one annual report he wrote,"To evaluate
[economic performance], we must know how much total capital—debt and
equity—was needed to produce these earnings." When he mentions return on
equity, generally it is with the proviso that debt is minimal.
If your data source does not give you return on capital for a company,
then it is easy enough to calculate it from return on equity. The two
basic ways that long-term debt is expressed are as long-term debt to
equity DTE and as long-term debt to capital DTC. (DTC is also referred to
as the capitalization ratio.) In the first case, return on capital ROC is
calculated from return on equity ROE by
ROC = ROE / (1 + DTE),
and in the second case by:
ROC = ROE * (1 - DTC)
For example, in the case of Abe, we saw DTE = 10,000 / 10,000 = 1 and ROE
= 40% so that, according to the first formula, ROC = 40% / ( 1 + 1) = 20%.
Similarly, DTC = 10,000 / 20,000 = 0.5 so that by the second formula, ROC
= 40% (1 – 0.5) = 20%. You might like to check your understanding of this
by repeating the calculations with the results for Zac's company.
If you compare return on equity against return on capital for a company
like General Motors with that of a company like Gillette, you'll see one
of the reasons why Buffett includes the latter company in his portfolio
and not the former.
For more articles, analyses, and insights into today's financial markets
from John Price, visit his web site.
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ROI Guide: Internal Rate of Return
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FEBRUARY 17, 2003 (COMPUTERWORLD) - Definition: The internal rate of
return (IRR) is the discount rate that results in a net present value of
zero for a series of future cash flows.
What it means: It's a cutoff rate of return; avoid an investment or
project if its IRR is less than your cost of capital or minimum desired
rate of return.
Strengths: It provides a simple hurdle rate for investment
decision-making. It's the method favored by many accountants and finance
people, possibly the ones at your company.
Weaknesses: It's not as easy to understand as some measures and not as
easy to compute (even Excel uses approximations). Computational anomalies
can produce misleading results, particularly with regard to reinvestments.
IRR is the flip side of net present value (NPV) and is based on the same
principles and the same math. NPV shows the value of a stream of future
cash flows discounted back to the present by some percentage that
represents the minimum desired rate of return, often your company's cost
IRR, on the other hand, computes a break-even rate of return. It shows the
discount rate below which an investment results in a positive NPV (and
should be made) and above which an investment results in a negative NPV
(and should be avoided). It's the break-even discount rate, the rate at
which the value of cash outflows equals the value of cash inflows.
Consider the three scenarios shown here (see table), each involving an
initial investment of $1 million. The investment returns $300,000
(undiscounted) per year in each of the five years after the initial
investment, for a net return of $500,000.
A company evaluating this investment using cash flow discounted at 10%
would compute an NPV of $137,000, a decent but not spectacular result. But
if the company evaluates the same investment at 15%, the project has a
present value of only $6,000, essentially just breaking even, and at 20%
the project's present value is negative. The IRR is a fraction of a
percentage point above 15%; at that discount percentage, the investment's
NPV is zero.
IRR is often used as a hurdle rate, a sort of go/no-go investment
threshold. Gaylord Entertainment Co. in Nashville, for example, has
computed its weighted average cost of capital—a percentage that it won't
disclose—and a "hurdle" percentage rate a few points higher. An
investment's IRR must generally equal or exceed the hurdle rate to be
approved by management, says CIO Kent Fourman.
"We calculate the IRR and then compare that to our hurdle rate," Fourman
says. "And we compare that IRR against every other [project's] IRR,
because you always have limited cash."
But the IRR cutoff isn't an absolute test, he says. For example,
management's subjective assessment of risk may influence an investment
decision, he says. "But if you can't show that IRR exceeds our hurdle
rate, then you'll have to have a lot of the soft justifications to get it
approved," Fourman says.
Not everyone is as enthusiastic about IRR. Like NPV, it doesn't measure
the absolute size of the investment or its return. And because of the way
the math works, the timing of periods of negative cash flow can affect the
value of IRR without accurately reflecting the underlying performance of
IRR can also produce misleading results because, as classically defined,
it assumes that the cash returned from an investment is reinvested at the
same percentage rate, which may not be realistic. That error is magnified
when comparing two investments of different durations. Some software, such
as Microsoft Excel, will compute an optional "modified IRR" that allows
the user to specify a different reinvestment rate.
IRR becomes increasingly misleading the more it diverges from the cost of
capital, says Ian Campbell, chief research officer at Nucleus Research
Inc. in Wellesley, Mass. "IRR is a terrible metric, and it should never be
used," he asserts.
The key metric for IT projects, Campbell says, is payback period, because
it favors short-term, and hence less risky, projects that IT should be
Internal Rate of Return: What It Looks Like
Discount rate: 10%Discount rate: 15%Discount rate: 20%
0-$1 million1.000-$1 million1.000-$1 million1.000-$1
Total+$500,000NPV = +$137,000NPV = +$6,000NPV =
IRR = slightly more than 15%
IRR is often used as a hurdle rate, a sort of go/no-go
investment threshold. In this example, there is an initial
investment of $1 million, with a net (undiscounted) return of
$500,000. The NPV of the $1 million outlay depends on the
discount rate, or cost of capital, used to evaluate the
investment. The NPV is zero at the IRR, here a fraction of a
percentage point above 15%.
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