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Return on equity: How to weigh up an investment's prospects

by , 09 November 2015

Investing is all about making money with the cash you put to work in shares. When weighing up a new investment opportunity, you want to know how hard your money is going to work for you.

One way to do this is to look at return on equity. You can then use the percentage you get from this calculation to compare with other investment prospects, allowing you to make a more informed decision.

So what exactly is return on equity?

Let's take a closer look…
 

What is return on equity?

 
Return on equity (ROE) is one way to compare what interest rate an investment pays. It allows you to compare interest rates with other investments just as you would compare what interest rates are on offer in different bank accounts.
 
Return on equity looks at a company’s post tax profits and compares this to the money invested by its shareholders (equity).
 

An example of using return of equity to compare investments

 
Company ABC has after-tax profits of R100 million. It also has equity of R500 million. This gives Company ABC a return on equity of 20% ((R100 million/R500 million) x 100).
 
On the other hand, Company XYZ has after-tax profits of R200 million and equity of R2 billion. This gives Company XYZ a return on equity of 10% ((R2 billion/R200 million) x 100).
 
Looking at the return on investment between Company ABC and Company XYZ shows that Company ABC is likely the better investment. This is because investors in Company ABC are seeing their money work twice as hard than if they’d invested in Company XYZ.
 

The downside of using return on equity

 
The only thing is, return on equity ignores money a company may have borrowed. And by borrowing a lot of money return on equity can increase. 
 
This can make a company look like a better investment. But a company that carries a lot of debt is also riskier.
 
To get past this issue, instead of using return on equity, you could use return on capital employed.
 
So there you have it. Using return on equity to weigh up an investment’s prospects.
 
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