Tag Archives | return on investment

ROE (Return on Equity)

See Also:
Return On Equity Example
Return on Asset
Financial Leverage
Gross Profit Margin Ratio Analysis
Return on Equity Analysis
Fixed Asset Turnover Analysis

Return on Equity (ROE)

The return on equity, or ROE, is defined as the amount of profit or net income a company earns per investment dollar. It reveals how much profit a company earns with the money shareholders have invested. The investment dollars differ in that it only accounts for common shareholders. This is often beneficial because it allows companies and investors alike to see what sort of return the voting shareholders are getting, if preferred, and other types of shares that are not counted.

The term can be confusing as it has various aliases. For example, Return on Equity used to be called Return on Common Equity; however, ROCE now refers to Return on Capital Employed. Return on Equity is also the equivalent to Return on Net Worth (RONW).

Return on Equity Explanation (ROE) 

ROE is a measure of how well a company uses its investment dollars to generate profits; often times, it is more important to a shareholder than return on investment (ROI). It tells common stock investors how effectively their capital is being reinvested. For example, a company with high return on equity (ROE) is more successful in generating cash internally. Thus, investors are always looking for companies with high and growing returns on common equity. However, not all high ROE companies make good investments. Instead, the better benchmark is to compare a company’s return on common equity with its industry average. The higher the ratio, the better the company.

(Are you trying to maximize the value of your company? The first thing to do is to identify “destroyers” that can impact your company’s value. Click here to download your free “Top 10 Destroyers of Value“.)

Return on Equity (ROE) Formula

The return on equity formula is as follows:

ROE = Net Income (NI)/ Average Shareholder’s Equity

The Net Income accounts for the full fiscal year (prior to dividends paid to common stock holders and after dividends paid to preferred stock holders).

Find the average shareholder’s equity by combining the beginning common stock for the year, on the balance sheet, and the ending common stock value. Then divide these two values by two for the average amount in the year and do not include preferred shares.

Don’t leave any value on the table! Download the Top 10 Destroyers of Value whitepaper.

ROE

Strategic CFO Lab Member Extra

Access your Exit Strategy Execution Plan in SCFO Lab. This tool enables you to maximize potential value before you exit.

Click here to access your Execution Plan. Not a Lab Member?

Click here to learn more about SCFO Labs

ROE

0

Normalized Earnings

Normalized Earnings

Normalized Earnings are adjustments made to the income statement in preparation to show potential buyers of the company. When making these adjustments, eliminate expenses not usually incurred for the production of the business. To show a more realistic return on investment, the normalized expenses should not appear on the future buyer’s income statement.

Different Types of Normalized Earnings

There are multiple types of special expenses that are unusual on a typical income statement. For now, let’s categorize them into two types of normalized earnings – Type A and Type B.

Type A: Non-Recurring Gains and/or Losses

The goal of “normalizing earnings” is to provide prospective buyers a typical income statement so they know what to expect. Expenses such as a lawsuit, non-operating assets, and other abnormal items that occur once are considered expenses you can eliminate when normalizing earnings.

Type B: Discretionary Expenses

Do not record certain expenses at fair market value price. Adjust these expenses so the buyer of a company does not assume these expenses incur regularly. If you include these expenses, then as the current company owners, you should specify that these expenses or earnings are not generating/generated by business. Examples include vacation homes, car rentals, startup costs, and unreasonably high bonuses.

(If you want to learn how to measure your company’s key performance indicators for free, then get it here!)

Normalized Earnings Example

For example, Laura Johnson is the CEO and founder of X company, and now wants to sell it. Her current business generated over $2 million last year, according to her income statement.

Normalized Earnings

Type A: Laura experienced a lawsuit and lost $250,000. Because this was one-time event, remove the lawsuit expense for adjustment purposes.

Type B: Laura’s sales team had a sales contest to boost revenue for the year 15%. As a result, two salespeople gained extremely high bonuses totaling to a $100,000 additional salary.

By normalizing these earnings, EBITDA increases by $350,000, earnings that the buyer can potentially make without those extra costs.

SCFO- Lead Magnet for KPI Discovery Cheatsheet

Strategic CFO Lab Member Extra

Access your Strategic Pricing Model Execution Plan in SCFO Lab. The step-by-step plan to set your prices to maximize profits.

Click here to access your Execution Plan. Not a Lab Member?

Click here to learn more about SCFO Labs

Normalized Earnings

See Also:
Key Performance Indicators (KPI’s)
Collection Effectiveness Index (CEI)
How Does a CFO Bring Value to a Company?
Multiple of Earnings
Continuous Accounting: The New Age of Accounting
Budgeting 101: Creating Successful Budgets

0

Analyzing Your Return on Investment (ROI)

return on investmentReturn on Investment is a useful tool to understand, analyze, and compare different investment opportunities. ROI measures the efficiency of a specific investment by revealing how net earnings recover the cost of the original investment. Have you ever wondered if the result of your investment was really worth the cost? Well, a return on investment model looks at the inputs and assumptions of the ROI equation to determine if the benefits of the investment are worth the costs. Following are the ROI model tools you need to analyze ROI and improve ROI. Then you can determine the value of your investment:

Analyzing Your Return on Investment (ROI)

The first step is to identify and analyze overall benefits from the investment. For different financial situations, the percentage of returns may vary according to what the decision-makers consider to be gains or losses from the investment. As long as you are consistent with how you classify benefits of the investment, you should be able to effectively use your calculations for analysis and comparisons. Focus on benefits which are measurable and attainable. Measure and evaluate tangible benefits to improve ROI percentages.

If the benefits appear significant, the next step is to identify and analyze associated costs of the investment. Costs are simpler to identify than benefits. Make a list of costs and then breakdown the costs into groups to better categorize the origination of costs. This will enable you to understand where the majority of costs are coming from. Are there any costs that appear inflated? Can you easily reduce some costs? Are there costs that could be eliminated completely? These questions will help you analyze expenses of the investment. Keep in mind that the cost of an investment includes not only the start-up cost, but also the maintenance and improvement of the investment over time.

Improve Return on Investment

To improve the return on your investment, business managers and directors should develop comprehensive and realistic projections for both revenues and expenses. Effective planning will account for unexpected expenses and underperforming sales revenue. By analyzing projections, you should be able to develop strategies to reduce costs and increase sales.

If you don’t want to leave any value on the table, then download the Top 10 Destroyers of Value whitepaper.

return on investment

Strategic CFO Lab Member Extra

Access your Exit Strategy Execution Plan in SCFO Lab. This tool enables you to maximize potential value before you exit.

Click here to access your Execution Plan. Not a Lab Member?

Click here to learn more about SCFO Labs

return on investment

0

Return on Investment (ROI)

See Also:
Return on Invested Capital (ROIC)
Return on Common Equity
Internal Rate of Return Method

Return on Investment (ROI) Definition

Return on investment (ROI) is the ratio of profit made in a financial year as a percentage of an investment. In other words, ROI reveals the overall benefit (return) of an investment using the gain or loss from the investment along with the cost of the investment.

Return on Investment Explanation

Return on investment is a useful and simple measure of how effective a company generates profits from an investment. Many firms use ROI as a convenient tool to compare the benefit of an investment with the cost of the investment. For example, if a company effectively utilizes an investment and produces gains, ROI will both be high. Whereas if a company ineffectively utilizes an investment and produces losses, ROI will be low. For investors, choosing a company with a good return on investment is important because a high ROI means that the firm is successful at using the investment to generate high returns. Investors will typically avoid an investment with a negative ROI, or if there are other investment opportunities with a positive ROI. Return on investment models are used often because the ROI ratio and inputs can be modified to fit different companies and financial situations.

Similar formulas to calculate profitability include return on equity, return on assets, and return on capital.

How to Find Return on Investment

The return on investment ratio calculates the percentage return (profitability) on an investment. Check out the following ROI formula:

Simple Return on Investment Ratio = (Earnings from Investment – Cost of Investment) ÷ Cost of Investment

One issue with the simple return on investment formula is that it is often used for short-term investments, so it does not account for the time value of money. Thus, it is less accurate for calculating ROI for long-term investments over one year. To measure the long term return on investment for future years, use the discounted ROI formula.

Discounted Return on Investment Ratio = Net present value of benefits ÷ Total present value of costs

= (PV Earnings from Investment – PV Cost of Investment ) ÷ PV Cost of Investment

Return on Investment Example

For example, this year, ABC company has produced earnings of $50,000 from an investment. The cost of the investment was $30,000.

Simple Return on Investment Ratio = ($50,000 – $30,000) ÷ $30,000 = 67%

Based on the result, we assume that ABC company has an annual percentage return on investment of 67%. The benefit (gain) was $50,000 and the investment cost was $30,000.

If you want to increase your return on investment, then you need to adopt our method of finding “destroyers” of value. Click here to download the Top 10 Destroyers of Value to maximize the value of your company.

Return on Investment (ROI)

Strategic CFO Lab Member Extra

Access your Exit Strategy Execution Plan in SCFO Lab.

Click here to access your Execution Plan. Not a Lab Member?

Click here to learn more about SCFO Labs

Return on Investment (ROI)

0

Risk Premium

See Also:
Finance Beta Definition
Hedging Risk
Common Stock
Preferred Stock
Stock Options

Risk Premium Definition

Risk premium is any return above the risk-free rate. The risk-free rate refers to the rate of return on a theoretically riskless asset or investment, such as a government bond. All other financial investments entail some degree of risk, and the return on the investment above the risk-free rate is called the risk premium.

When an investor purchases a financial instrument, such as stock or bonds, that investor is putting his capital at risk. The company that issued the stock could perform poorly and its stock could plummet in value; or the company issuing the bonds could default and its bonds could become worthless. Both of these potential scenarios represent risk for the investor or speculator. The return on an investment, which corresponds to the riskiness of the investment, is supposed to compensate the investor for that risk.

Different financial instruments have different degrees of riskiness and the returns on these instruments typically correspond with the level of risk. More risky assets have higher returns; less risky assets have lower returns. An asset with no risk, such as a U.S. government bond, has a comparatively low rate of return because there is little or no risk of the U.S. government defaulting. Therefore, the rate of return on that type of riskless asset is referred to as the risk-free rate. Any return above that rate is a risk premium which compensates the investor for the riskiness of the asset.

Risk Premium Example

Assume the risk-free rate is 5%. This means a riskless U.S. government treasury bond offers an annual return of 5%. Let’s say an investor invests in the stock of a company and that stock has an annual return of 7%. The risk premium for that company’s stock is the difference between the risk-free rate of 5% and the expected return of the stock of 7%. So the risk premium is 2%.

Risk Premium = Asset Return – Risk-Free Rate

2% = 7% – 5%

Risk Premium and the CAPM

The risk premium is also used in calculating the expected return on asset when using the capital asset pricing model (CAPM). In that case, the risk premium combines the market risk premium, or the overall stock market’s return above the risk-free rate, with the beta of the individual stock. This gives the risk premium for the particular stock over the risk-free rate.

risk premium

0

Return on Equity Analysis

See Also:
Financial Ratios
Return on Asset
Required Rate of Return
Return on Invested Capital (ROIC)
Debt to Equity Ratio
Return on Common Equity (ROCE)
What The CEO Wants You to Know How Your Company Really Works

Return on Equity Analysis

Defined also as return on net worth (RONW), return on equity reveals how much profit a company earned in comparison to the money a shareholder has invested.

Return on Equity Explanation

This term is explained as a measure of how well a company uses investment dollars to generate profits. Return on equity is more important to a shareholder than return on investment (ROI) because it tells investors how effectively their capital is being reinvested. Therefore, a company with high return on equity is more successful to generate cash internally. Investors are always looking for companies with high and growing returns on equity. However, not all high ROE companies make good investments. The better benchmark is to compare a company’s return on equity with its industry average. Generally, the higher the ratio, the better a company is.

Are you in the process of selling your company? The first thing to do is to identify “destroyers” that can impact your company’s value. Click here to download your free “Top 10 Destroyers of Value“.

Return on Equity Formula

The following return on equity formula forms a simple example for solving ROE problems.

Return on Equity Ratio = Net income ÷ Average shareholders equity

When solving return on equity, equation solutions only form part of the problem. Thus, one must be able to apply the equation to a variety of different and changing scenarios.

Return on Equity Calculation

Average shareholders’ equity, or return on 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. Unfortunately, no simple return on equity calculator can complete the job that a solid understanding of ROE can.

For example, a company has $6,000 in net income, and $20,000 in average shareholders’ equity.

Return on equity: $6,000 / $20,000 =30%

In conclusion, a company that has $0.3 of net income for every dollar that has been invested by shareholder.

Return on Equity Example

Melanie, after seeing success in her corporate career, has left the comfortable life to become an angel investor. She has worked diligently to select companies and their managers, hold these managers accountable to their promises, provide advice and mentoring, and lead her partners to capitalization while minimizing risk. At this stage, Melanie is ready to receive her pay-out. Melanie wants to know her Return on Equity analysis ratio for one of her client companies.

Melanie begins by finding the net income and average shareholder’s equity for the venture. Looking back to her records, Melanie has invested $20,000 in the business. Her net income from it is $6,000 per year. Performing her return on equity analysis yields the following results:

Return on equity: $6,000 / $20,000 =30%

Melanie is happy with her results. Because she was purposeful and started small, she built the experience and confidence to be successful. She can now move on to bigger and better deals.

If you’re looking to sell your company, download the free Top 10 Destroyers of Value whitepaper to learn how to maximize your value.

return on equity analysis

Strategic CFO Lab Member Extra

Access your Exit Strategy Checklist Execution Plan in SCFO Lab. The step-by-step plan to get the most value out of your company when you sell.

Click here to access your Execution Plan. Not a Lab Member?

Click here to learn more about SCFO Labs

return on equity analysis

Resources

For statistical information about industry financial ratios, please go to the following websites: www.bizstats.com and www.valueline.com.

0

Profitability Index Method Formula

See Also:
Profitability Index Method

Profitability Index Method Formula

Use the following formula where PV = the present value of the future cash flows in question.

Profitability Index = (PV of future cash flows) ÷ Initial investment

Or = (NPV + Initial investment) ÷ Initial Investment: As one would expect, the NPV stands for the Net Present Value of the initial investment.

Profitability Index Calculation

Example: a company invested $20,000 for a project and expected NPV of that project is $5,000.

Profitability Index = (20,000 + 5,000) / 20,000 = 1.25

That means a company should perform the investment project because profitability index is greater than 1.

Profitability Index Example

Texabonds Inc has decided to consider a project where they predict the annual cash flows to be $5,000, $3,000 and $4,000, respectively for the next three years. At the beginning of the project, the initial investment put into the project is $10,000. Use the Profitability Index Method and a discount rate of 12% to determine if this is a good project to undertake. In order to solve this problem, it is probably a good idea to make a table so that the numbers can be organized by year.

Using a PI table, the following PVIF’s are found respectively for the 3 years: .893, .797, .712. Once the PVIF’s are determined, simply multiply the cash flows and the PVIF’s together in order to get the PV of cash flows for each respective year ($4,465, $2,391, $2,848). Adding up all the PV’s will get the total present value of the project which is $9,704. Divide that final number by the original investment $10,000 and the PI has been determined: .9704. As one can see, the Profitability Index is less than 1 so the project should be scrapped. The NPV can also be determined by subtracting the initial investment ($10,000) from the total PV of the project ($9,704) and you are left with -$296. In this case, because the number is negative, NPV also says that the project should be rejected.

Profitability Index Formula Table

A table for the problem is shown below:

YearCash FlowPVIF at 12%PV of Cash Flow
1$5,000.893$4,465
2 3,000.797 2,391
3 4,000.712       __2,848__

If you want to learn how to price profitably, then download the free Pricing for Profit Inspection Guide.

Profitability Index Method Formula

Strategic CFO Lab Member Extra

Access your Strategic Pricing Model Execution Plan in SCFO Lab. The step-by-step plan to set your prices to maximize profits.

Click here to access your Execution Plan. Not a Lab Member?

Click here to learn more about SCFO Labs

Profitability Index Method Formula

7