ShmoopTube

00:00

principles of finance a la shmoop ROE. it's not a type of sushi. when

00:08

financial managers think about the word returns ,they're not thinking about you [ man in suit smiles]

00:12

know that blouse washed me out so I'm taking it back to Macy's for a different

00:16

color. rather they're thinking about financial returns of the flavor oh we

00:21

put a dollar in today and we expect a lot more than a dollar back in a few

00:25

years. that's financial return and there are really two primary measures managers

00:30

rely on return on assets ROA or return on equity, ROE. all right well the

00:36

broader concept just asks am i investing well? well ROA measures the financial

00:42

return investors received over the course of a year, generally. and is

00:46

calculated as return divided by total assets. so what kind of return goes in

00:51

the numerator here? well it could be net income you know the only problem here is

00:56

that net income sometimes has one-time charges ie a lawsuit that was settled

01:01

and you know we lost, or it could have big losses this year which won't happen

01:05

again next year, so we backed them out. well maybe we call this recurring

01:10

returns so we can subtract out the one-timers. yeah that works all right [equation for recurring returns]

01:13

well what about taxes and interest costs in a volatile interest rate world? what

01:18

do we do about those and what about one-time gains on a sale of a subsidiary

01:21

which carried a lot of debt and tax losses with it? translation? yeah it's all

01:25

very complicated. well most managers get past all that

01:28

noise by ignoring net income and instead reporting operating earnings. so check

01:34

this out our revenues cups liquid rent labor and five six to five yeah there we

01:39

go. in this little model it's the $7,500

01:42

figure, and we scan our balance sheet for you here at no extra charge from

01:47

Schmucks current and cents and pounds of sugar. all right so we have one hundred

01:51

eighteen thousand bucks in total assets. very interesting and that these are the

01:56

numbers three days before the Super Bowl transaction and they're not pretty, right?

02:00

from one hundred eighteen thousand dollars in total assets we've only been [balance sheet pictured]

02:04

able to take out seventy five hundred bucks in operating profits. you could

02:09

have invested that money in a lot of places and done way better than the six

02:12

percent returns that it implies, but if you wait

02:15

a few days and the transaction happens, depending on the deal structure well all

02:20

the sudden you have something more like fifty thousand dollars in operating

02:23

profits with about the same total assets so all of a sudden your ratios look a

02:28

whole lot better. moral of the story, sales matter. having tons of accounts

02:33

receivable are nice but they aren't sales. sales convert inventory to cash,

02:38

and that generally speaking is a good thing. so if you had operating profits of

02:42

fifty thousand dollars in total assets of a hundred thousand then your ROA

02:46

would be 50%. think about it in the form that if you had invested $100,000 this [equation]

02:53

year to just buy those assets and you already got half your money back, well

02:57

you'd be doing exceedingly well. big number. you're swinging. ROE is a

03:02

different measure of how well managers are doing in returning earnings to

03:07

shareholders. ROE uses fully taxed earnings or net income after everything

03:13

dead included and it puts it in the numerator.

03:16

why use fully taxed and include interest costs well because in this case ROA is

03:21

quote wedded unquote to the common equity of the firm or rather the equity

03:26

value of the firm. a big part of the equity value as far as earnings goes [ROE and equity value get married]

03:30

includes basically everything. well as the common owner you are the backstop

03:35

the last word the final say so you have to pay for everything. so everything

03:39

should be included in this calculation. hopefully not surprising then the common

03:43

equity or shareholders common stock equity is the denominator. and our little

03:49

balance sheet above that would be the ninety eight thousand dollar figure

03:52

right there - if our net income was nine thousand eight hundred in a given year

03:56

then applying Fancy Pants math we'd have ROES ten percent right ?and oh by the

04:01

way in any of these calculations where you take a year's income in whatever

04:05

form operating net income da da da you know you put it over the

04:09

beginning of the year balance sheet item. why? because at the beginning of the year [equation]

04:13

you have your finite universe of assets with which to manage. based on those

04:18

resources you then generate returns for the subsequent following year. so the

04:24

denominator is kind of easy. shareholders common

04:27

stock equity at the beginning of the year, that's it so next time you hear about

04:30

ROE, don't think about that sushi think about the Benjamins you pay to eat

04:34

it. [man grimaces at restaurant bill]

Full Transcript