Return on Equity (ROE) and Internal Rate of Return (IRR) Explained

Part I:  Return on Equity (ROE)


Return on Equity (ROE), or also referred to as, “The mother of all ratios,” that can be gathered from the financial statement of the company; in its simplest terms, is defined as profits divided by the book value of shareholder’s equity.  ROE provides investors a tool by which to measure the three keystones of corporate management, these are profitability, financial leverage, and asset management.  By analyzing how accurately the executive team balances these important factors, investors can not only see if they will receive an excellent ROE, but also get a keen sense of management efficiency.  It shows a company how much profit they earned correlated to the shareholder total amount of equity on the balance sheet. 


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)


 Photo by krakenimages on Unsplash

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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