Return On Equity Formula

Return On Equity Formula

The return on equity formula is the most common profitability ratios used by equity shareholders to judge the effectiveness of their funds invested in a firm.

The return on equity formula is a key formula when determining how well a company can use shareholder money to grow the company. A company with a low return on equity may be using shareholders money inefficiently. We can come to the conclusion that the return on equity formula is a formula that aims to help the shareholders, not the company itself.

Net worth includes all contributions made by equity shareholders, including paid-up capital, reserves and surplus

Keep in mind that financing decisions made by management can affect RoE, for example, assume that companies A and B earn similar operating profits of $100 and have the same tax rate of 30%. Also assume that both the companies have employed capital of $1000. However, company A employs only equity and company B employs debt at 15% interest rate, and equity in the ratio of 3:7. The following table depicts the difference in RoE of both the companies based on these assumptions.

Company A B
PBIT $100 $100
Interest – $15
PBT $100 $85
Tax (30%) $30 $25.5
Net Profit $70 $59.5
Net Profit margin 70.00% 59.50%
Equity employed $1000 $700
Debt employed – $300
Return on Equity 7.00% 8.50%

In this case, even though both the companies have earned similar operating margins, company B has a higher return on equity, to the tune of 8.50%. This is due to the leverage used by company B. While B provides higher return on equity to shareholders, it is also riskier compared to A which carries no debt. Similarly, RoE is also influenced by the average cost of debt and tax rates.

Remember, the return on equity formula is often used by shareholders to determine how much money the company is making relative to the amount of shareholder equity.

Return On Capital Employed

Return On Equity Formula

Our next profitability ratio, return on capital employed, or RoCE indicates the efficiency and effectiveness of a company’s capital investments.

Return on capital employed should always be higher than the rate at which the company borrows, it should earn more than the cost of funds it applies in the business. The company may face liquidity issues if the interest costs on its debt are more than the return gained on the employed capital.

For a company that has fluctuating capital, a more suitable ratio would be return on average capital employed, which uses the average of opening and closing capital employed during a given period of time. Simply substitute total assets and current liabilities for their averages.

Below is an example of the return on capital employed formula in action:

Bobs plumbing company reported a operating profit of $ 200 000. Bob also claimed he had $150 000 in total assets and $ 60 000 in total liabilities.

Return on Capital Employed = $200 000 / $150 000 – $60 000

RoCE = 2.22

What this means, is that every dollar that bob invested in employed capital, he seen a return of $2.22. This number is higher than normal, but the example is to just show you how to punch numbers into this simple formula.

While all these profitability ratios throughout these articles provide valuable insight into a company’s financial performance during the operating cycle, the analyst should be aware of manipulation techniques used for distorting the income statement before drawing any conclusions based upon these profitability ratios.

Risk Management

Risk Management

Risk management is absolutely critical in the success of an active trader. Without prudent risk management, it is very possible for trader to lose their entire account in just a couple of trades. Risk management helps you understand the potential downside to every trade and make informed decisions on each trade you take.

To start with basic risk management, a trader needs to understand the concept of support/resistance lines, stop-loss and profit taking. In essence, risk management is about calculating the probability of winning and making the soundest trading decisions. A good trader will need to know where to enter a position and where to exit a position. If the potential reward when compared to the potential risk is favorable enough, the trade is executed.

To a new trader, an easy way to determine this is by looking at the support and resistance line. For example: In a long scenario, the difference between the current price of the stock to the next line of support versus the difference between the current price of the stock to the next line of resistance is called the risk/reward, or R/R ratio. As you probably might have guessed, a low risk and high reward ratio makes a favorable trade. A general rule of thumb of a good trade is 1/3. If the stock price drops below your designated line of support, you would sell the stock immediately, and if the stock price hits your target at the line of resistance, you will cash out and take profits. Another popular way of setting R/R is using a pair of Moving Averages, or MA.

Not all trades you take will hit your profit target

In fact, only a small percentage of the trades will, and for those that do not, you will have to cut losses immediately. To enforce this, traders often use stop-loss function to liquidate their positions immediately. The stop-loss is triggered automatically by your broker. Keep in mind though, if you have a DRIP set up, you will no longer be buying the fractional shares as you have sold the security!

Understandably, many traders do not feel comfortable with taking a loss and therefore, do not adhere to the cut-loss point 100% of the time. The stop-loss insures that this does not happen and a loss will always be cut before it gets out of hand.

Overall, the strategies used in making your trades can vary greatly and the examples mentioned here is by no means a hard rule. The key is that you have a very clear idea of when you will enter and when you will exit a trade. Effective risk management involves having a clear idea about the risks involved and ensuring that you do not break your rules.

A Little Investing Advice – Are Bonds Better Than Stocks?

A Little Investing Advice – Are Bonds Better Than Stocks?

 

Bonds might not exactly be as visible in the media as stocks. There’s much more excitement that surrounds the area of stocks which makes them discussed in the press far more. In reality, there are investors who have never heard of a bond even though they may have dabbled in the stock market and even looked at instruments like traded funds and futures. However, the fact remains that though bonds might not be the as high profile and very often pull in lower returns, they are probably safer and healthier.

You can strike it rich with stocks!

Stocks have a certain thrill that comes attached to them. Picture yourself buying a stock and waking up the next day to  its  value  increasing by 10%. It can heady, that feeling. And of course, investors who watch their stocks duplicate in some months feel that they are incredibly smart or they are incredibly lucky! Yet inbuilt with the joy factor is also the factor of risk. Stock prices are extremely volatile and what goes up, up, up can come crashing down in a moment, totally unexpectedly. Really often, the swings can be very large and rapid indeed.

 

are bonds better than stocks

So what makes bonds appealing? Are bonds better than stocks?

 

Bonds on the other side of the coin have a more boring tag attached to them. But if you look strong, they do come in a variety to choose from – reliable and unexciting U. S. or corporate AAA 10-year ones that give you a steady but small produce to junk bonds that can give you more than 15%! With bonds, too, you have to weigh them with the same principles as you would to stocks – the calculated risk factor against the rewards you wish to get. This is the standard trade-off. Nevertheless, the risks in the bond market are substantially lower and what is even more comforting, they may be easy to calculate.

 

You need more money with bonds

 

You will need more capital for the first investment in bonds. You may only get one bond for a hundred shares of $10 stock. You’ll also find mutual funds that invest mainly in a genuine and your broker could advise you about other choices like ‘pay as you go’ plans. The trouble with bonds is the fact that you can’t trade them as easily as you would stocks and shares. As far as stocks go, for the majority of all of us, it’s a matter of a few clicks of the mouse. Bonds, however, need you to make that mobile phone call and not all providers can be traded through brokers. Bonds also entice a higher commission. Begin focusing check with your dealer who will list out the options for you.

Anytime you are looking at the short-term, bonds are definitely less volatile. Nevertheless, one thing they are sensitive to is interest rates. Bonds always have a coupon rate while shares have dividends which one could look at as interest being paid on the stocks though this might be sometimes skewed in line with the whims of the management. Where bonds are concerned, the coupon rate is fixed during the time when they are issued. So if you are planning to sell your bonds, particularly before their date of maturity, this rate will be in contrast to other investments that give interest. So you will discover that the prices of bonds are damaged by not only what their coupon rate is but also how far they have to go before their maturity. Bonds tend to be more inspired by government policies than stocks are. What could affect bonds are substantial borrowings, which could suggest the government issuing bonds or by setting the prime rate lending rates or thanks to legal guidelines that had an effect on insurance companies, banking institutions or large institutions.

As a result what seems to emerge is that it will pay to have a diversified portfolio. Whether you directly buy them or perhaps you have them thanks to your mutual funds, bonds mean much more safety and will be a welcome addition to your investments.