Return on Investment (ROI) vs Equity (ROE): What are the differences?
Return on investment (ROI) and return on equity (ROE) are both measures of performance and profitability. A higher ROI and ROE is better. Beyond that, do you understand the major details and differences between the two measurements?
It’s important to understand so that you can make good decisions when investing and, more importantly, track the performance of your investments so you know when to continue with an investment or move along.
ROI vs. ROE
Let’s break this down very simply beginning with ROI. The formula for ROI is “gain from investment” minus “cost of investment” then divided by the “cost of investment” and multiplied by 100. This calculation is incredibly simple and gives a good idea of the gain made on the investment in terms of a percentage.
This term is very common in investing and is one of the most popular measurements of performance and efficiency. It is a handy equation to have in your toolkit when comparing investments to maximize your investing efficiency.
ROE is also a simple equation that calculates how much profit a company can generate based on invested money. The basic formula is “net income” divided by “shareholder equity.” Dividends can play a role in this calculation where they will not factor in for common stocks but should be a part of net income when including preferred stocks.
Both calculations can show you if a company is doing well on the surface but there are some very important differences between ROI and ROE. Knowing which equations to use and how to use them is incredibly important.
Return on Equity can be used for:
- Comparing profitability of companies or investments
- Factoring in debt when considering investment profitability
- Evaluating cost opportunity
Return on Investments can be used for:
- Clear profitability before debt
- Simple percentage allows easy comparison of investments
- Identify good management
Which calculation should you consider?
Both of these calculations should be a part of your research when considering investments. Used together, they can be strong indicators of investment profitability. If you use one formula but not the other then you may miss some important information.
Understanding the formula also helps you better analyze news reports like, for example, if you were to see that long-term expected annual return for US large cap stocks (i.e., the S&P 500) is 5.9% then you know the ROI formula used to get that number.
Each formula has its own strengths and weaknesses. As with most calculations, good data in will produce good data out. Examining ROI over a long period of time may show a nice percentage number on the surface but the yearly return may be exceedingly low.
A high ROE could be an indicator of a strong investment but the numbers could also be propped up by debt that could come back to haunt you in the future.
Let’s sum it up
ROE is a good calculation when researching stocks and allows you to compare companies in similar industries. However, you do have to be careful to examine the debt held by companies as it may artificially inflate the ROE to make it seem as though an investment has strong performance when really it has more debt to service.
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