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Finance: What are Return on Equity and Return on Assets? 145 Views
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What are Return on Equity and Return on Assets? Return on equity is a percentage that is found by dividing net income by shareholder’s equity. It can be used to determine growth and financial health, but differs greatly among sectors, so only similar companies should be compared using ROE. Return on assets divides net income by total assets; this tells investors how profitable a company is given what they have.
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Transcript
- 00:00
finance a la shmoop. what are return on equity and return on assets? all right
- 00:09
return on equity ROE .what is it? and no it's not that stuff that they stick on [sushi on a plate]
- 00:15
the outside of sushi. it's the kissing cousin of ROA if that helps. so what
- 00:20
is return then in this instance huh? well it's just profits. and there's a broader
- 00:24
frame here to think about. if your company just made five million dollars
Full Transcript
- 00:27
in profits, was that good bad middlin? well if you were a little lemonade stand
- 00:32
that took 50 grand to start last year and you've made this massive five
- 00:37
million dollar haul well then yeah wow that's awesome. but if you're Google and
- 00:41
this year you only made five million bucks well you have tens of billions of
- 00:45
dollars of capital out there trying to earn lots more while making only five
- 00:50
million was a huge fail. so these concepts revolve around the balance
- 00:54
sheet remember this thing well here are assets, and if your General Electric the [balance sheet shown]
- 00:58
asset side is enormous. say with the notional fifty billion dollars in assets
- 01:03
if you made a ten percent return on your assets or raw ROA
- 01:09
return on assets well that would mean you netted five billion dollars right?
- 01:13
ten percent of 50 billions five billion. your return on assets was ten percent [math equation shown]
- 01:17
there. so remember equity or shareholders equity or retained equity on the balance
- 01:22
sheet yeah this thing right here what equity is the retained profits after
- 01:26
you've started to build your company and after years and years of building your
- 01:29
company you would expect to have a lot of retained earnings. so what were the
- 01:33
returns on that equity or ROE only returns or profits number is the same as
- 01:39
it was in the ROA calculation only now in the denominator we have equity so if
- 01:44
your returns were say five billion and your retained equity was twenty billion [equations shown]
- 01:48
well you had a lovely twenty five percent return this year. twenty five
- 01:52
percent of twenty billion you know five billion. meaning that in just this one
- 01:56
year you grew your retained equity one massively. you've become a big harvester [man lifts weights]
- 02:01
of cash profits from whatever great business it is that you built. well why
- 02:06
do we care about ROA and ROE? well because capital efficiency
- 02:11
matters. it's a reflection of how efficient you are, how well you're
- 02:14
investing your capital how will you're able to grow the business. that is in
- 02:18
theory you could just sell your assets and go invest them elsewhere, like go
- 02:22
play an index fund in the stock market, and potentially return better profits
- 02:26
for your shareholders, and if you can do that well then you're probably going to
- 02:30
get fired. and there is precedent for this change .the airline industry there [airplane taking off]
- 02:37
was a time when American Airlines and United Airlines and crash Airlines owned
- 02:43
all their airplanes. they bought them at 50 million bucks a pop give or take but
- 02:47
the airline industry is a lousy business producing very low cash profits. every
- 02:52
time the economic cycle is good the economy is good people are buying
- 02:56
airline tickets up the wazoo, the Union strike and the airline's try to do
- 03:00
stupid things with pricing and a bunch of other things happen and all the
- 03:03
profits go away. anyway so one day a smart MBA employed by the airline said
- 03:09
hey dudes why don't we just lease the airplanes from Boeing or whoever makes [man speaks to group]
- 03:14
them and we only need a fraction of our assets or equity or capital to produce
- 03:18
about the same investment returns for our shareholders. yeah and that's what
- 03:22
they did. so most airlines these days don't own
- 03:24
their own planes they lease them from the manufacturer or others and well
- 03:29
there haven't been any airline bankruptcies lately. and yes the airline
- 03:33
industry hard to find a better success story. [plane takes off]
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