Return on Equity - ROE
Hi friends, first round of posts with 3 value from 3.
So in the two previous posts I explained what ROI is, which is actually the return of an investor (or any other entity) to new investments regardless of how the investment is financed and before taxes,
And I explained what ROA is, which is the return that the investor's total assets have created regardless of the financing of the investment and before taxes.
In this post I would like to explain the ROE financial ratio
(return on equity)
Or in Hebrew a return on capital (equity).
What you usually do is compare and emphasize the difference between ROI (return on investment)
And ROE (Return on Equity).
Between ROA (return on assets)
And ROE (Return on Equity).
In both cases, the meaning of ROE can be understood equally. I will explain the difference between ROI and ROE.
The way to calculate ROE is to distribute the net profit in equity.
Net profit is net income, that is, income minus all expenses (including financing expenses and payment of taxes on income).
Equity is the money I brought home when I went into an investment.
The purpose of the ROE ratio is to measure at what rate our equity grows.
In the post I explained ROI (ROI), I used the following example:
Let's assume an asset that costs $ 100,000 and the property generates annual rental income of $ 14,000 and assumes that management company is 1400 $ annual, annual insurance $ 1000, and $ 2000 City taxes and we receive operating income (EBIT) of $ 9600 (2000 - 1000 - 1400 - 14000).
So the ROI will be 9600 (EBIT) divided by 100,000 (total investment) and we will get a ROI of 9.6%.
Ie the asset generates a return on investment of 9.6%.
Now let's say two situations for buying the property:
1: Equity only (ie I bring the entire investment cost as money from home).
In other words, I invested $ 100,000 and at the end of the year I stayed with 9600 $ operating profit (EBIT) ie profit before deducting financing expenses and deducting tax expenses. In this case financing expenses will be zero because I brought all the money to buy the property from home (I did not take a loan from anyone) and therefore there is no financing expenses (interest), as we will have to pay tax on our profit, suppose the tax rate is 10% $ We will pay a tax of $ 9600
(10% * 9600) so that it remains with a net profit of 8640 $ (960 $ - 9600 $) and therefore in this case the return on equity will be 8.64% calculation is: 8640 $ (net profit) divided by 100,000 $ (equity).
In other words, it can be seen that the return on investment (ROI) is 9.6% and the return on equity (ROE) is 8.64%. The gap between the yields derives from the payment of taxes taken into account in the calculation of ROE versus the ROI in which the tax payment was not taken into account.
Mode 2: How financing will be 40,000 $ Equity (money from home) and another $ 60,000 loan.
Let us assume that the annual interest on the loan is 3% for a period of 4 years and the loan is repaid according to the Grace repayment schedule (prominent among those who know this name), the meaning of the repayment of the loan according to the repayment schedule Grace is that the 60,000 loan will be repaid in one payment at the end of the loan period Years) and until then each month interest will be paid only on the loan.
The annual interest expense will be 1800 $ (3% * 60,000 $), the monthly interest payment will be 150 $ (1800 $ divided by 12).
Now we will look at what will happen at the end of the year: the return on investment (ROI) will be 9.6% because the operating profit will be 9600 $ divided by $ 100,000 (investment). For what does it matter where we brought the money ?? The property is expected to generate 9.6% of the money we invested in it before interest and before tax expenses.
Now considered the net profit:
Operating Profit (EBIT): $ 9600
Less interest expenses on the loan: $ 1800
We will receive a pre-tax profit: 7800 $
We deduct tax expenses (we assumed 10% as in 1 mode): 780 $ = 10% * 7800 $
We will get a net profit: $ 7020 = $ 780 - $ 7800
Now we consider ROE (return on equity):
7020 $ (40,000 $) equity (which the investor brought from home) and we will assume that the return on equity is 17.55% = ROE.
You can see that although the investment can only generate "9.6%" with leverage (using our own money), we have succeeded in increasing our equity (our money in the deal!) By 17.55%.
The gap between ROI and ROE is called leverage yield, ie, how much surplus we have managed to generate on our capital beyond return on investment by leveraging leverage.
In our example, leverage will be 7.95% (9.6% - 17.55%).
What is our conclusion?
That with smart leverage you can take a pretty boring investment with an average return and achieve great growth in our equity. Of course, the condition for this is that the return on investment will be higher than the cost of interest, because if not, the leverage we took will increase our loss.
It is important to note that leveraging merely reinforces an existing situation, that is, if we make a profit then leveraging will boost our profits and if we lose leverage leverage us losses.
Sometimes the body that accompanies us money for investment can condition the loan by choosing investments in a lower risk profile, which is usually characterized by a lower yield, but at the end of the day an investment that embodies a lower yield may prove to be a more worthwhile investment than another investment with a higher expected yield because the investment Less risky It is very possible that the lender will agree to give money at a lower interest rate, which will be translated directly into ROE.
The bottom line: This return on investment (ROI) is very important, but the return on equity (ROE) shows us how much equity we have brought from home.
And therefore in every investment we have to look at all the data and give an emphasis to each given data and its implications.
Hope you produced 🙂 value
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tags: ביטוח Management companies מימון Taxation Taxes A poem yield