To calculate the
ROE, there are two different formula methods, the Traditional formula, and the DuPont
formula. The Traditional formula divides
the company’s earnings of one year by the average shareholders’ equity
(adjusted for stock splits) of that year, which is then, denoted as a
percentage. However, the traditional
formula does not take into consideration borrowed funds, which could increase
the returns. Therefore, another method
is used. The DuPont formula joins return
on investment (ROI) to financial leverage (use of debt).
The ROE formulas are:
Traditional Formula: ROE = Net
Profit (after taxes) ÷ Average Shareholder Equity for
Period
(Ready Ratios, 2011).
DuPont
Formula: ROE =
Net Profit (after taxes) / Stockholders’ Equity
ROE = (Net Profit
(after taxes)/ Total Assets) x (Total Assets/
Stockholders’
Equity)
A good ROE varies
between 13 percent and 15 percent. Even though there are advantages to ROE, such
as aiding investors in determining if companies are creating profits or not;
compare rival companies earnings data; and measuring tool for efficiency in
profits and management. There are disadvantages
as well to ROE.
The ROE can be pseudo inflated;
the division of a smaller book value, caused by borrowing funds, not issuing
stocks, accomplishes this. By the taking
of stock buy backs, write-downs, and etc. the book value can be decreased,
resulting in an increase in ROE, simultaneously, the profits are not
increased.
Many experts in the financial
world suggest examining an ROE for a longer time, not just, for the past year
ROE, in return, eliminating abnormal numbers that will provide a more practical
view. Moreover, many investors use ROE
as a mechanism for searching competitively profitable companies. Over a long period, companies that propagate
profits with their available assets, exemplify a more advantageous and viable
in financial terms investment.
Part II: Internal
Rate of Return
A useful
number to know when assessing an investment is the Internal “hidden” Rate of
Return (IRR), which helps to solidify if an investment is worth pursuing. IRR calculates the discount rate at which the
Net Present Value (NPV) of the cost of the project is equal to the expected NPV
of the benefits; this is when the NPV of the project whole equals zero. In simple
terms, the IRR is the discount rate (expressed in percentage) where the NPV is
equal to zero.
The higher the IRR of a project, the more propitious
it is to launch a project. IRR can be
used to judge several potential projects an organization is examining for
investment; considering all the various projects have equaling factors. Furthermore, the project that has the highest
IRR is considered the best project to undertake first.
Some firms set hurdle rates for potential
investments, and the rates are commonly expressed in terms of IRR, such as a
company might require a 16% IRR or more to approve a project. The IRR has both advantages and
disadvantages.
The Advantages of IRR:
· Takes into consideration the time value of money.
· Hurdle rate/required rate of return is not necessary for
finding out IRR, therefore, the risk of determining a wrong hurdle rate is
alleviated.
· True measure of profitability because it uses both inflows
and outflows present values, not arbitrary assumptions or subjective
applications.
· A project with higher IRR than Weighted Average Cost of
Capital (WACC) is launched, it results in an increase of shareholder’s return,
and the firm’s value also increases.
The Disadvantages of IRR:
· The actual dollar value of benefits is not acknowledged.
· Can have a mix of both positive and negative future cash
flows.
· It disregards the
respective size of the investments.
· Problems when deciding between mutually exclusive projects.
· Discount rates alter over the project’s life cannot be
amalgamated into IRR calculations.
· IRR does not make a distinction between lending and
borrowing projects, hence, a higher IRR may not be recommended.
· Multiple IRR’s can be generated when projects have
non-normal or unconventional cash flows.
· Because cash flows are discounted at the contingency cost
of capital, the discounting rate may be hard to determine, if the long-term and
short-term rates are not the same.
Part III: Comparison of Two Firms ROE
The ROE for two renowned companies
in the electronics industry, Apple, Inc. and Panasonic Corporation, are as
follows, (for this evaluation and comparison, the Traditional Method will be
used):
ROE=Net Profit (after taxes) ÷ Average Shareholder Equity
for
Period
(Ready Ratios,
2011).
I) Apple, Inc. (based on 2011 Annual Report)
25,922,000 ÷ 76,615=
ROE
25%
This means that Apple Inc. generated $0.25 of profit for
every $1 of shareholders’ equity last year, giving the stock an ROE of
25%.
II) Panasonic (based on 2011 Annual Report)
8,692,672 ÷ 2,558,992 =
ROE
8%
This means that Panasonic Corp. generated $0.08 of profit
for every $1 of shareholders’ equity last year, giving the stock an ROE of
8%.
The ROE
determines how well a company utilizes investment dollars to produce profits,
which is more important to a shareholder than Return on Investment (ROI). It postulates to an investor how
efficaciously their capital is being reinvested. In the evaluation of Apple, Inc.
and Panasonic Corporation’s ROE, Apple Inc., has a higher ROE of 25% than
Panasonic at 8%, a difference of 17%.
Therefore, Apple Inc. is more successful to generate cash internally, than
Panasonic. The industry average ROE for consumer
electronics is 14.75%.
Panasonic is -6.75% of the industry average for ROE, while Apple is +10.25%
above the industry average for ROE.
Clearly, Apple Inc. is the company with higher ROE, especially when
comparing the two companies with the average ROE by sector, thus, Apple Inc. is
the better company because of its high ROE and management efficiency, in comparison
to Panasonic’s ROE.
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