A firms growth rate is 8%, the ROA = 10%, the debt ratio is 20%. The stock is selling at $36. What is the return on equity?
Definition of 'Return On Equity - ROE'
The amount of net income returned as a percentage of shareholders equity. Return on equity measures a corporation's profitability by revealing how much profit a company generates with the money shareholders have invested.
ROE is expressed as a percentage and calculated as:
Return on Equity = Net Income/Shareholder's Equity
Net income is for the full fiscal year (before dividends paid to common stock holders but after dividends to preferred stock.) Shareholder's equity does not include preferred shares.
Also known as "return on net worth" (RONW).
Investopedia explains 'Return On Equity - ROE'
The ROE is useful for comparing the profitability of a company to that of other firms in the same industry.
There are several variations on the formula that investors may use:
1. Investors wishing to see the return on common equity may modify the formula above by subtracting preferred dividends from net income and subtracting preferred equity from shareholders' equity, giving the following: return on common equity (ROCE) = net income - preferred dividends / common equity.
2. Return on equity may also be calculated by dividing net income by average shareholders' equity. Average shareholders' equity is calculated by adding the shareholders' equity at the beginning of a period to the shareholders' equity at period's end and dividing the result by two.
3. Investors may also calculate the change in ROE for a period by first using the shareholders' equity figure from the beginning of a period as a denominator to determine the beginning ROE. Then, the end-of-period shareholders' equity can be used as the denominator to determine the ending ROE. Calculating both beginning and ending ROEs allows an investor to determine the change in profitability over the period.
Definition of 'Return On Assets - ROA'
An indicator of how profitable a company is relative to its total assets. ROA gives an idea as to how efficient management is at using its assets to generate earnings. Calculated by dividing a company's annual earnings by its total assets, ROA is displayed as a percentage. Sometimes this is referred to as "return on investment".
The formula for return on assets is:
Note: Some investors add interest expense back into net income when performing this calculation because they'd like to use operating returns before cost of borrowing.
Investopedia explains 'Return On Assets - ROA'
ROA tells you what earnings were generated from invested capital (assets). ROA for public companies can vary substantially and will be highly dependent on the industry. This is why when using ROA as a comparative measure, it is best to compare it against a company's previous ROA numbers or the ROA of a similar company.
The assets of the company are comprised of both debt and equity. Both of these types of financing are used to fund the operations of the company. The ROA figure gives investors an idea of how effectively the company is converting the money it has to invest into net income. The higher the ROA number, the better, because the company is earning more money on less investment. For example, if one company has a net income of $1 million and total assets of $5 million, its ROA is 20%; however, if another company earns the same amount but has total assets of $10 million, it has an ROA of 10%. Based on this example, the first company is better at converting its investment into profit. When you really think about it, management's most important job is to make wise choices in allocating its resources. Anybody can make a profit by throwing a ton of money at a problem, but very few managers excel at making large profits with little investment.
15.0%
To calculate the return on equity (ROE), we need to use the formula: ROE = ROA * (1 - Debt Ratio). Here's how to calculate it using the given values:
Step 1: Calculate (1 - Debt Ratio)
Debt Ratio = 20% = 0.20
(1 - Debt Ratio) = 1 - 0.20 = 0.80
Step 2: Calculate ROE
ROA = 10% = 0.10
ROE = ROA * (1 - Debt Ratio)
= 0.10 * 0.80
= 0.08
Step 3: Interpret the Result
The return on equity (ROE) for the firm is 8%, which means for every dollar of shareholders' equity, the firm generates 8 cents of profit.
It's worth noting that the stock's selling price of $36 doesn't provide any direct information to calculate the return on equity (ROE). ROE is a measure of profitability based on the firm's internal financial ratios.