Investing in Stock -pt 6

Today I want to conclude my series on investing in stocks by looking at one last ratio of which most of you have probably heard, return on capital employed.  This ratio is also referred to as return on equity or ROE for short.  It measures the return that a company/shareholder earns on the capital that it has invested in the business.  It is calculated by finding the ratio of the net profit before tax to the equity of the company.  The equity of the company is the sum of the share capital and the ordinary reserves or for our purposes the retained earnings of the company.

Let us use the following information as an example:

Net profit before tax      $180million
Ordinary share capital  $600million
Retained earnings           $150million

The calculation would be $180/(600+150) *100% = 24 per cent.

Thus our company has returned a rate of 245 on its equity i.e. the total money that is invested to finance the business.  This rate will now be compared with the return that could be earned from other investments.  If interest rates are higher than the rate that the company can make on its investment then there would be a disincentive to starting or expanding the business.  Running a company is a lot of hard work and there are many regulations that have to be followed.  Why go to all of that trouble when one can simply invest your money with government and sit back and relax.  This is one of the reasons why Jamaica experienced so little growth during the last twenty years, high interest rates killed the entrepreneurial spirit of Jamaican investors.

Another good comparison for the ratio is to measure it against the rate of inflation.  This will enable one to tell if the company is achieving real growth.  If the rate of inflation in our example is 18 per cent then the real growth is 24 – 18 = 6 per cent.  Thus the company has been able to grow the company at a rate that exceeds inflation.  If a company can constantly grow at a rate exceeding inflation then it is a good indicator of the future viability and success of the company.

I hope that you have enjoyed the first of several series on investing that I will do for you.  Please let me have feedback on what you have seen and any particular areas that you would like me to have a look at.

Tags: Carl Wilson