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- How to Determine the Required Rate of Return for Equity
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You come across two figures when analyzing a company to see if it is financially healthy: return on investment and return on equity. You may find a strong ROE for a company but further investigation may reveal a poor ROI. Understanding the difference in the way these two figures are calculated helps you understand a company’s true financial picture before you invest in it through stocks or bonds.
Return on Equity Advantages
Knowing the percentage of income a company makes on its equity helps you understand whether the company is profitable. Equity includes the original investment plus any money borrowed to fund company activities. A healthy company will show a rate of 20 percent ROE or more. This positive return indicates the company uses its money wisely.
Return on Equity Disadvantages
Since equity includes invested funds and borrowed funds, a company could have too much debt to remain profitable in the long term. Investment guru Warren Buffet examines a company’s equity to see how much of it came from debt. Dun and Bradstreet suggests that a company should have twice as much income as the debt payments cost. If debt rises so high that a company does not have two times as much income as debt service, it could be running into trouble.
Return on Investment Advantages
When you measure a company’s return on the money investors placed in it, you get a clear picture of what the company makes before it has to borrow money. If you find a positive number when looking at ROI, you know the company has a sound return, and that it uses borrowing to expand, rather than using debt to survive. When the original investment makes money, this indicates sound management.
Return on Investment Disadvantages
Since ROI excludes debt, you can find a positive ROI on a company that carries more debt service than it can sustain. Make sure that the ROI excludes income from capital improvements made with debt. If ROE is positive and ROI is negative, you know that the company uses debt to make its current income, and that the return on investment is not sufficient to sustain the company.