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finance a la shmoop. what are return on equity and return on assets? all right

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return on equity ROE .what is it? and no it's not that stuff that they stick on [sushi on a plate]

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the outside of sushi. it's the kissing cousin of ROA if that helps. so what

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is return then in this instance huh? well it's just profits. and there's a broader

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frame here to think about. if your company just made five million dollars

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in profits, was that good bad middlin? well if you were a little lemonade stand

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that took 50 grand to start last year and you've made this massive five

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million dollar haul well then yeah wow that's awesome. but if you're Google and

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this year you only made five million bucks well you have tens of billions of

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dollars of capital out there trying to earn lots more while making only five

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million was a huge fail. so these concepts revolve around the balance

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sheet remember this thing well here are assets, and if your General Electric the [balance sheet shown]

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asset side is enormous. say with the notional fifty billion dollars in assets

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if you made a ten percent return on your assets or raw ROA

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return on assets well that would mean you netted five billion dollars right?

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ten percent of 50 billions five billion. your return on assets was ten percent [math equation shown]

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there. so remember equity or shareholders equity or retained equity on the balance

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sheet yeah this thing right here what equity is the retained profits after

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you've started to build your company and after years and years of building your

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company you would expect to have a lot of retained earnings. so what were the

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returns on that equity or ROE only returns or profits number is the same as

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it was in the ROA calculation only now in the denominator we have equity so if

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your returns were say five billion and your retained equity was twenty billion [equations shown]

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well you had a lovely twenty five percent return this year. twenty five

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percent of twenty billion you know five billion. meaning that in just this one

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year you grew your retained equity one massively. you've become a big harvester [man lifts weights]

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of cash profits from whatever great business it is that you built. well why

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do we care about ROA and ROE? well because capital efficiency

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matters. it's a reflection of how efficient you are, how well you're

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investing your capital how will you're able to grow the business. that is in

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theory you could just sell your assets and go invest them elsewhere, like go

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play an index fund in the stock market, and potentially return better profits

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for your shareholders, and if you can do that well then you're probably going to

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get fired. and there is precedent for this change .the airline industry there [airplane taking off]

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was a time when American Airlines and United Airlines and crash Airlines owned

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all their airplanes. they bought them at 50 million bucks a pop give or take but

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the airline industry is a lousy business producing very low cash profits. every

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time the economic cycle is good the economy is good people are buying

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airline tickets up the wazoo, the Union strike and the airline's try to do

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stupid things with pricing and a bunch of other things happen and all the

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profits go away. anyway so one day a smart MBA employed by the airline said

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hey dudes why don't we just lease the airplanes from Boeing or whoever makes [man speaks to group]

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them and we only need a fraction of our assets or equity or capital to produce

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about the same investment returns for our shareholders. yeah and that's what

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they did. so most airlines these days don't own

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their own planes they lease them from the manufacturer or others and well

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there haven't been any airline bankruptcies lately. and yes the airline

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industry hard to find a better success story. [plane takes off]

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