Return on common stockholder's equity, often abbreviated as ROE, is perhaps the single most important factor influencing the value of your investment portfolio. In simple terms, this ratio tells you how profitably the firm's management is using the money that you and other shareholders have entrusted to it. Various factors influence this all-important figure.
Return on equity equals Net Profit divided by Shareholder Equity. Assume, for instance, that you invest $400,000 in a laundromat, which yields net profits of $40,000 per year. Your ROE is $40,000 / $400,00 or 0.1. Multiplying this result by 100 allows you to convert the figure into a percentage. In this case, 0.1 x 100 results in 10 percent ROE. In other words, you gain 10 cents for each dollar you invest into this laundromat. This figure is the most important parameter to look at when comparing investment alternatives. Provided that various investments involve similar risk levels, invest in the opportunity with the highest ROE.
Gross margin defines how profitable your sales are and is a major determinant of your ROE. The formula for gross margin is gross profit divided by net sales multiplied by 100. Gross profit equals net sales minus cost of goods sold. In the laundry example, assume that direct expenses, such as water, electricity and depreciation on the washing machines was $120,000 for the year and your total sales proceeds were $200,000. Your gross profit is therefore $200,000 - $120,000 = $80,000. Gross margin equals $80,000 / $200,000 x 100 = 40 percent. On average, you are taking in 40 cents for each dollar in sales. This 40 cent figure, however, does not include indirect expenses, which also affect ROE.
All indirect expenses that are not dependent on how much product or service you manufacture/supply are grouped under overhead expenses. These include such things as rent, salaries of staff not involved in manufacturing or supplying the main service, advertising and so on. A firm whose overheads are low in comparison to sales is said to run a "lean" operation. How low the overhead expenditures must be in comparison to sales, however, entirely depends on the industry. In the pharmaceutical sector, firms must invest huge sums in research and development to stay competitive. A utility firm supplying water to a local community, on the other hand, will have relatively low overheads.
How much a firm borrows and what interest it pays for those borrowed funds plays a key role in determining its ROE. If you borrow an additional $400,000 and enlarge your laundromat, your sales will likely far exceed the previous level of $200,000 for the year; and so will your gross profit. If the increase in gross profits is greater than the added overheads and interest expense on the loan, your net profit, also known as your bottom line, will also grow. Since you have expanded operations with no extra money out of pocket, shareholder equity will remain the same, and your ROE will grow. Should the expansion not bring in sufficient profit to justify the extra expenses associated with it, however, your ROE will drop.
Hunkar Ozyasar is the former high-yield bond strategist for Deutsche Bank. He has been quoted in publications including "Financial Times" and the "Wall Street Journal." His book, "When Time Management Fails," is published in 12 countries while Ozyasar’s finance articles are featured on Nikkei, Japan’s premier financial news service. He holds a Master of Business Administration from Kellogg Graduate School.