Return On Equity - ROE

Finance a la shmoop What is r o e or

a return on equity when you go to a fancy

sushi bar while those little orange eggs cost a small

fortune they come from libertarian salmon and tastes like assault

licked from your grandmother's purse So that's row but well

has nothing to do with this kind of row or

return on equity Different thing Alright so very simply Anytime

you see a ratio that's return on anything It means

profits in the numerator Sitting on something in the denominator

like return on sales is a company's profit margin right

You have profits divided by sales and well that's Pretty

easy calculation to make if you have the data so

return on equity Well that's a little bit different in

that finding What you mean by equity is sometimes a

bit of a moving target or a religious discussion in

the way the equity line on the balance sheet was

in fact calculated In essence the equity value of a

company is what it owns over time Like it accumulates

equity profits in the brand equity and patents and a

whole bunch of other crap And it owns all that

Got it it's The equity value of the firm like

the cash profits is generated over a long period of

time with the cash it's received from investors plus fair

value of all the patents and brands and distribution infrastructure

and eighteen zillion other elements that all add up together

when you subtract liabilities from assets to get that either

that's the yeah they all come together to comprise whatever

number is placed as the equity of the firm So

if you go back to our friendly little lemonade stand

with twelve grand in profits or returns and equity of

thirty six grand then it's row is yes one third

or thirty three percent Well is that good Bad ugly

Well in a vacuum we don't really know Because each

industry command such different kinds of numbers when it comes

to the efficient use of its equity a lemonade stand

needs well relatively very little capital expenditure to get started

It should have very high returns from its equity because

its profit margin should be very high When it's selling

for a dollar something that costs a dime you can

think of that thirty three percent return on equity as

being something that might map to investing in a stock

market reflective index fund and yes thirty three percent a

year return from any kind of stock market investment Overtime

is heroic The problem While the return number is likely

highly volatile in a company with such massive return on

equity that is yes So this year our little lemonade

stand made twelve grand But next year it might lose

five the following year make twenty and then the following

year well goes bankrupt So the r o e number

for a company is so fragile what's on the edge

of meaningless really compare the row for a large oil

company Well oil is massively less volatile as an industry

That is our little lemonade stand and oils One of

the more volatile industries just light A match there happened

and twenty billion dollars well just buys you a well

some storage tanks a little distribution infrastructure and hopefully a

decent line Teo getting your money back eventually So if

you measure the return on equity of a big oil

company over a ten year cycle well you might find

that return is only four and a half percent Well

That equity could have been deployed almost certainly in the

investing community like an index finding factor whatever and done

much better than what the managers of the oil company

did in putting all that money in the ground through

wells and exploration and refining and so on So is

an unschooled investor You might begin to be leaning on

management to take their cash and do something else with

it Like how about investing it in an internet search

company Yeah we need another one of those You know

those google people had really high r o e let's

do more of that And then one day a bomb

goes off in the middle east Big one Oil prices

go from fifty bucks a barrel to one hundred And

for the following decade the r o e of the

oil company looks a lot more like that Thirty three

percent fromthe lemonade company And the investor who pushed shell

to fund a google competitors goes back to work making

fives and tens and change at bank of america and

pushing customers to you know refinance their more Well the

bottom line is that are we is a moving target

At best and only exists in the vague never land

of time And that contextually It only means something when

mapped against the whole host of other things that players

could do with their money So if you're companies trying

to stay above water and you start smelling something fishy 00:04:16.772 --> [endTime] well you know it might just be the row