The decisive factor for an investment is the return on equity or return on equity. In company analysis, this figure is just as important as the cash flow and the return on capital. The return on equity indicates how profitably an investor invested or how profitably a company operates. The calculation formula is not identical for the individual investment segments, but it is similar.
- The return on equity shows how profitable an investment will be.
- Low interest rates and high rents are beneficial when it comes to mortgage lending. Then there is a high return on equity.
- If a company loses, the return on equity is negative.
Return on Equity – this is how the return on equity is determined
The determination of the profitability of a company’s equity is derived from the capital employed and the profit generated from it. The formula is: Profit / Equity * 100. Calculation example : A company has equity of 5,000,000 euros and generates a profit of 1,000,000 euros. The return on equity is a solid 20 percent.
The basis for determining the return on equity are profit and equity . The profit is the profit according to the profit and loss account (P&L), adjusted for the taxes due on it.
It is not uncommon for profits to be increased by using loans , i.e. borrowed funds, in addition to the equity capital invested. In this case, there is a leverage effect. As long as the expenses for borrowed capital are lower than the profit generated, the leverage effect has a positive influence. Information on the equity of a company can be found in the company reports.
How high should the return on equity be?
Short for ROE by abbreviationfinder, the return on equity should be higher than the return on a government bond of issuers with top credit ratings . In contrast to these bonds, an investment in other forms of investment presupposes a certain willingness to take risks on the part of the investor, as there is a fundamental risk of default. This willingness to take risks must be compensated by the risk premium factored into the return.
The return on equity on stocks
An investor who invests in stocks naturally wants to generate the most attractive return possible with the money invested . As an investor, he must look for stocks that have a high return on equity. A good size is between 20 and 30 percent.
However, it is not just about the company’s key figures, as it is not certain how much of the profit generated will be distributed to the shareholders. If the return is 30 percent, but the investment is fully in new production facilities, the investor gets nothing.
The relationship between the entry price and the dividend actually paid out is helpful when determining the return on the investment . The price / earnings ratio also shows whether the share is attractive, but ultimately does not provide any information about the actual amount of the distribution.
The return on equity in mortgage lending
Anyone who buys real estate for letting to third parties usually finances it. The already mentioned leverage effect plays a special role when buying real estate when building interest rates are at a very low level but rents are at a high level. This constellation arose directly (in the case of interest) and indirectly (in the case of rents) as a result of the financial crisis in 2009. The lower the equity capital used, the higher the return.
How is the return on equity determined when renting? The classic property buyer finances the property. The rental income is offset by expenses for interest and non-apportionable ancillary costs. As a result, the rental income must be adjusted for the costs in order to then consider it in relation to the capital employed.
First, the investor has to determine the annual net income of the property . The formula is quite simple: annual rental income – interest – non-apportionable additional costs = annual net income.
With the formula annual net income / equity * 100 = return on equity , this important figure can also be determined very easily. Calculation example: Assume that with equity capital of 80,000 euros and rental income of 15,000 euros, 3,000 euros are incurred. This results in a return on equity of (15,000 – 3,000) / 80,000 * 100 = 15 percent.
The negative return on equity
If a company or investment generates a negative return on equity, all alarm bells should ring for investors. In the field of mortgage lending, a negative return on equity can arise if the leverage effect occurs through an increase in interest rates over rental income. This can be the case if the interest rate for follow-up financing is far higher than that which was valid at the start of the financing.
A company experiences a negative return on equity when the company is making losses.
However, extremely high depreciation from investments in past periods can flow into the income statement. Although these can put a strain on the books, they have no effect on liquidity. In the case of a negative return on equity in companies, special attention should therefore be paid to depreciation.
The return on total assets
The return on assets , in English return on investment (ROI), estimates the return on total in a company’s existing capital, consequently includes debt with one. The return on investment answers the question ” How efficiently does a company work? ”
There are two parameters required to determine the return on total capital:
- The profit after tax plus the interest on borrowed capital, as this is the remuneration for the borrowed capital to be taken into account.
- The total capital (balance sheet total), which consists of equity and debt.
Mathematically, the total return on capital is determined using this formula : (profit + interest) / total capital * 100.
If the company profit is 100,000 euros, interest on debt is 5,000 euros and the total capital is 1 million euros, the following applies: (105,000 / 1,000,000) * 100 = 10.5 percent.