Return on Investment Vs. Return on Equity
Return on investment (ROI) and return on equity (ROE) are ways to measure management effectiveness, parts of a system of measures that also includes profit margins for profitability, price-to-earnings ratio for valuation, and various debt-to-equity ratios for financial strength. Without a set of evaluation metrics, a company's financial performance can not be fully examined. ROI and ROE calculate the rate of return on a specific investment and the equity capital respectively, assessing how efficient financial resources have been used.
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Return on Investment
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ROI is simply expressed as income/investment. For example, if a house was bought for $100,000 and a year later sold for $110,000, return on investment can be calculated as $10,0000/$100,000=10 percent. However, if there was a down payment of $20,000, ROI for the homeowner's own money is calculated as $10,000/$20,000=50 percent. Therefore, the result depends on which investment is being measured. There is no single definition as to what investment must be used in the calculation. Investopedia explains ROI in a broad sense, describing it as rate of return on any investment that the user intends to measure. In businesses, investments may refer to fixed assets, such as machinery and buildings, financed by long-term debt plus equity. The encyclopedia section of Entrepreneur magazine also defines ROI in multiple ways but specifically includes return on long-term investments.
Return on Equity
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ROE is defined as income/shareholders' equity. For example, if shareholders contributed $100,000 to a business and income was $20,000 for the year, ROE is calculated as $20,000/$100,000=20 percent. But the formula does not say whether there was debt involved to help generate the $20,000 income alongside shareholders' equity. So alternatively the original formula can be decomposed and expressed as return on total assets timed by equity multiplier, equal to total assets/shareholders' equity. For example, if there was $40,000 borrowed funds also used in the operation, ROE can then be calculated as $20,000/$140,000*$140,000/$100,000=20 percent. The new model, known as the DuPont formula, shows how ROE would have been lower without the asset base enlarged by borrowing. With financial leverage, even a poorly managed company could post a magnified income, states Russell Investments, owner of the widely used family of Russell indexes.
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The Flexibility of ROI
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Because of the versatility of how an investment can be defined, with ROI, profits can be measured against anything from some simple sales expenses to many complex fixed asset investments. The flexibility of ROI makes it suitable to measure any aspect of a business's performance, while ROE is used solely for measuring equity performance. When an investment includes both long-term assets and current assets, ROI becomes return on assets, the so-called ROA, another common measure of a business's investment effectiveness. If an investment being measured is made through the use of only shareholders' equity capital, ROI is effectively ROE.
The Reliability of ROE
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It is known that financier Warren Buffett favors the use of ROE over any other rate-of-return measures, including the mostly reported EPS, or earnings per share, explained Robert Hagstrom in his 2001 book "The Essential Buffett." When shares or investments are used as the base-line denominator when calculating ROI, because number of shares may stay constant and assets, if shown net of depreciation, can be reduced, it is possible that a small increase in earnings could produce larger increase on ROI, distorting actual financial performance. If equity is used as the base line, because income earned during the year is added onto the equity base that expands over time, any increase in ROE results only from real increases in earnings, making ROE a more reliable measure.
Potential Manipulation
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There is a potential downside with the flexibility of ROI. When the measurement can be expressed in many different ways, a user can easily manipulate ROI to suit his or her own purposes. Whenever presented with such data, the reader needs to make certain what the inputs are, warns Investopedia. As to ROE, even though it is an accurate measurement, be aware of a company's debt situation. Without the accompanying information on the use of leverage, shareholders can be caught off guard if ROE suddenly drops as debt is due and repaid, reducing total asset base and lowering income earning capacity.
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