Advantages and Disadvantages of IRR & ROE
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Valuation by ROE and IRR with an example. List advantages and disadvantages.
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Solution Summary
The solution explains what IRR & ROE is and lists the advantages and disadvantages of both. It includes tables with examples (2 computer companies) and formulas and 4 references.
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Valuation by ROE and IRR
Return on Equity:
Return on equity (ROE) is the tool used measure a corporation's performance by determining how it uses its assets to generate earnings (Motley Fool, 2011). The three components of ROE are profitability, asset management, and financial leverage. Profit is figured from the total money left after paying all the company costs. Asset management refers to how the company chooses to manage the assets in order to get the most usage. Financial leverage defines how the company controls its debt (in reference to creating more capital), realizing that too much debt is not a good thing. A company's ROE shows how much of the assets are created for every dollar invested. Because ROE is for annual computations, it is better to calculate the average for five years to determine a company's trend.
To calculate the ROE, use the formula below:
ROE = Annual earnings / shareholder equity
Advantages of using ROE (against all other methods):
One positive aspect of ROE is that it incorporates a company's strength among the competition and shows if the managers are handling the money well. It is a composite return of all assets and does not net out any cash. ROE can be performed on any company level to see which activities should be grown and which deceased. The weaknesses include the fact that ROE is sensitive to leverage (Ex. it will increase if debt proceeds are invested at better rate than borrowing rate) and ...
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