Return on Equity vs. Return on Capital

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Return on Equity:

The formula for calculating Return on Equity is:
Net Profit / Shareholder's equity

Return on equity reveals how much profit a company earned in comparison to the total amount of shareholder's equity found on the balance sheet. A business that has a high return on equity is more likely to be one that is capable of generating cash internally. For the most part, the higher a company's return on equity compared to its industry, the better. This should be obvious to even the less-than-astute investor If you owned a business that had a net worth [shareholder's equity] of $600 million dollars and it made $36 million in profit, it would be earning 6% on your equity [$36M / $600M = .06, or 6%]. It is also known that return on equity is particularly important because it can help you cut through the garbage spieled out by most CEO's in their annual reports about, "achieving record earnings". The return on equity figure takes into account the retained earnings from previous years, and tells investors how effectively their capital is being reinvested. Thus, it serves as a far better gauge of management's fiscal adeptness than the annual earnings per share.

While ROE is a useful measure, it does have some flaws or disadvantages that can give you a false picture, so never rely on it alone. For example, if a company carries a large debt and raises funds through borrowing rather than issuing stock it will reduce its book value. A lower book value means you are dividing by a smaller number so the ROE is artificially higher. It may also be more meaningful to look at the ROE over a period of the past five years, rather than one year to average out any abnormal numbers.

IRR (Internal Rate of Return)

Often used in capital budgeting, it's the interest rate that makes net present value of all cash flow equal zero. Essentially, this is the return that a company would earn if it expanded or invested in itself, rather than investing that money elsewhere. In other words, if you have an investment ...