principles of finance a la shmoop ROE. it's not a type of sushi. when
financial managers think about the word returns ,they're not thinking about you [ man in suit smiles]
know that blouse washed me out so I'm taking it back to Macy's for a different
color. rather they're thinking about financial returns of the flavor oh we
put a dollar in today and we expect a lot more than a dollar back in a few
years. that's financial return and there are really two primary measures managers
rely on return on assets ROA or return on equity, ROE. all right well the
broader concept just asks am i investing well? well ROA measures the financial
return investors received over the course of a year, generally. and is
calculated as return divided by total assets. so what kind of return goes in
the numerator here? well it could be net income you know the only problem here is
that net income sometimes has one-time charges ie a lawsuit that was settled
and you know we lost, or it could have big losses this year which won't happen
again next year, so we backed them out. well maybe we call this recurring
returns so we can subtract out the one-timers. yeah that works all right [equation for recurring returns]
well what about taxes and interest costs in a volatile interest rate world? what
do we do about those and what about one-time gains on a sale of a subsidiary
which carried a lot of debt and tax losses with it? translation? yeah it's all
very complicated. well most managers get past all that
noise by ignoring net income and instead reporting operating earnings. so check
this out our revenues cups liquid rent labor and five six to five yeah there we
go. in this little model it's the $7,500
figure, and we scan our balance sheet for you here at no extra charge from
Schmucks current and cents and pounds of sugar. all right so we have one hundred
eighteen thousand bucks in total assets. very interesting and that these are the
numbers three days before the Super Bowl transaction and they're not pretty, right?
from one hundred eighteen thousand dollars in total assets we've only been [balance sheet pictured]
able to take out seventy five hundred bucks in operating profits. you could
have invested that money in a lot of places and done way better than the six
percent returns that it implies, but if you wait
a few days and the transaction happens, depending on the deal structure well all
the sudden you have something more like fifty thousand dollars in operating
profits with about the same total assets so all of a sudden your ratios look a
whole lot better. moral of the story, sales matter. having tons of accounts
receivable are nice but they aren't sales. sales convert inventory to cash,
and that generally speaking is a good thing. so if you had operating profits of
fifty thousand dollars in total assets of a hundred thousand then your ROA
would be 50%. think about it in the form that if you had invested $100,000 this [equation]
year to just buy those assets and you already got half your money back, well
you'd be doing exceedingly well. big number. you're swinging. ROE is a
different measure of how well managers are doing in returning earnings to
shareholders. ROE uses fully taxed earnings or net income after everything
dead included and it puts it in the numerator.
why use fully taxed and include interest costs well because in this case ROA is
quote wedded unquote to the common equity of the firm or rather the equity
value of the firm. a big part of the equity value as far as earnings goes [ROE and equity value get married]
includes basically everything. well as the common owner you are the backstop
the last word the final say so you have to pay for everything. so everything
should be included in this calculation. hopefully not surprising then the common
equity or shareholders common stock equity is the denominator. and our little
balance sheet above that would be the ninety eight thousand dollar figure
right there - if our net income was nine thousand eight hundred in a given year
then applying Fancy Pants math we'd have ROES ten percent right ?and oh by the
way in any of these calculations where you take a year's income in whatever
form operating net income da da da you know you put it over the
beginning of the year balance sheet item. why? because at the beginning of the year [equation]
you have your finite universe of assets with which to manage. based on those
resources you then generate returns for the subsequent following year. so the
denominator is kind of easy. shareholders common
stock equity at the beginning of the year, that's it so next time you hear about
ROE, don't think about that sushi think about the Benjamins you pay to eat
it. [man grimaces at restaurant bill]