Return on Equity and Internal Rate of Return, Research Paper Example

When investing in a new company or making any sort of acquisition it is important to analyze how successful the company is on a scale that equalizes differences between diverse companies. One such measure is Return on Equity, or ROE. It is extremely easy to calculate, as it is just earnings over shareholder equity for some defined period of time. Shareholder equity can be figured out from the balance sheet, as it is just assets minus liabilities. The way to look at ROE is a measure of how much money the company earns per asset that it currently has in its possession. One variant of ROE is the DuPont Method, in which ROE is broken down further into three groups to analyze where exactly the company is successful or unsuccessful. The three categories here are operating efficiency, asset use efficiency, and financial leverage. They are represented by profit margin, asset turnover ratios, and equity multipliers respectively. Multiplying these three by each other will give the ROE (Investopedia).

The advantages to ROE to analyze companies are numerous. For one, it provides an important guideline about growth. A company is incapable of growing faster than its ROE without taking on additional liabilities (McClure). Another is that is measures the efficiency of the company. Unlike just normal profit in which larger firms have a significant advantage, Return on Equity, does not penalize smaller firms.

For all the insights it can have, ROE does have some drawbacks. For one, as is normal in financial ratios, they can only allow a certain level of comparison. One issue is that two companies in different industries with similar ROE cannot be compared and considered approximately equally successful. Another is the very nature of the formula. By putting equity as the denominator, the ROE will rise as equity falls. A company whose value suddenly declines will find itself with a higher ROE. Finally, defining shareholder equity is difficult due to the issues with calculating the value of intangible assets. How individual accounting departments tackle this problem will cause differences in the ROE calculated.

Internal rate of return is another measure for analyzing the effectiveness of potential investments. Simply it measures the total return on an investment. Those investments with internal rates or return higher than the cost of capital will be advisable for a company to take on. Some companies will only accept those investments significantly higher than the cost of capital to give them some margin for error and lower returns than expected. This is perhaps the great benefit of IRR, that it gives a simple decision making process that is often accurate. It is complex to calculate, especially compared to an easy formula such as ROE. It is related to the time value of money and net present value concepts. Microsoft Excel has function that makes calculation much easier than that done by hand.

Beyond the complexity of calculating it, IRR has other issues. For one, it assumes that cash earned during projects will be reinvested and earn similar rates during the project, which is often impractical. It does not work for comparing two investment opportunities as it can overstate the importance of initial returns. For these reasons, many recommend using the net present value of a cash flow and not its internal rate of return to calculate its actual value (Anthes).

As earlier stated, there is little value to ROE when comparing companies that operate in different industries. For that reason, the companies whose ROE will be calculated here are very similar, Target and Wal-Mart, both large retail chains. According to Yahoo Finance, Walmart had assets of 180 billion for their 2011 report. Their total liabilities at the same equaled 111 billion, meaning 69 billion worth of stockholder equity. The net income was 16.389 billion (Yahoo! Finance). This gives an ROE of .238.

Target, the main competitor of Wal-Mart, is not quite as big, but ROE allows for comparison of the two directly anyway. As of their 2011 report, the assets equal 43 billion, liabilities of approximately 28 billion, leaving just over 15 billion in equity for shareholders. Their net income was 2.92 billion dollars in the fiscal year ending January 2011. This gives a return on equity of .188 (Yahoo! Finance). This shows that Wal-Mart is not just the bigger of the two companies, but manages a more efficient usage of its equity as well.

Works Cited

“Decoding DuPont Analysis.” Investopedia. Web. 10 Dec. 2011. <http://www.investopedia.com/articles/fundamental-analysis/08/dupont-analysis.asp>.

McClure, Ben. “How Return On Equity Can Help You Find Profitable Stocks.” Investopedia.   Web. 10 Dec. 2011.   <http://www.investopedia.com/articles/fundamental/03/100103.asp>.

“Target Corp.” Yahoo! Finance. Yahoo. Web. 10 Dec. 2011.  <http://finance.yahoo.com/q/is?s=TGT+Income+Statement&annual>.

“Understanding Return on Equity.” Fool.com: Stock Investing Advice | Stock Research. Motley Fool. Web. 10 Dec. 2011. <http://www.fool.com/investing/beginning/return-on-equityan-introduction.aspx>.

“Wal Mart Stores Inc.” Yahoo! Finance. Yahoo. Web. 10 Dec. 2011. <http://finance.yahoo.com/q/is?s=WMT+Income+Statement&annual>.