How to calculate Return on Equity?

[Snoopy]

I worked out ROE for last 7 years.

2001	2002	2003	2004	2005	2006	2007	Year
							
643	191	704	775	806	2656	3024	Net profit after taxes
614	670	709	775	806	820	955	Adjusted net earnings
5403	5537	5199	5360	5605	5555	5582	Operating Revenue
7421	7500	7755	8246	8972	6203	8276	Total assets
2003	1328	1776	2617	2612	1062	3604	Total Equity
							
30.65%	50.45%	39.92%	29.61%	30.86%	77.21%	26.50%	ROE (du point)
							
32.10%	14.38%	39.64%	29.61%	30.86%	250.09%	83.91%	ROE

So telecom nz been doing well in terms of ROE over the years? Surely better than having the money in the bank looking at ROE?

There are a couple of things you need to bear in mind Jackie, that makes the return, from an investor perspective, not as attractive as it might casually appear.

If you buy shares in Telecom you become a shareholder and you get your slice of shareholders equity - that's true. However you cannot buy shareholders equity on its own. You also have to buy your fair share of shareholder debt which is included in the purchase price of the Telecom shares you buy. You have to buy the shareholders equity AND debt, which together add up to the sum of the company assets, as part of one purchase package.

So? you say. That only means I get the Du Pont return instead of the 'classic' ROE return. The Du Pont return may be less than the classic (84% in this case) return, but it is still much better than the bank return, so buying in is still a good deal - right?

I am sorry to inform you that most of those financial types who graze on the sharemarket for a living have figured this out before you. So let's say your Dupont ROE return for Telecom is 26.5%. Let's say our sharemarket punter has their money in the bank at 9%. On paper it looks like an easy swap. Take your money invested at 9% out of the bank. Put your money into Telecom and voilà your income has more than doubled!

In practice you can't more than double your return by doing this. That's because 'the market' ensures that an arbitrage adjustment on the Telecom purchase price exists. Let's say you want to buy $10,000 worth of Telecom. The market will ensure that instead of paying $10,000 for this 'investment package' you will actually pay around:

$10,000 x (26.5%/9%) = $29,444.

Thus even though you are getting 26.5%, you have to pay more than the nominal coupon rate (called 'the market price') to get it. Thus your $10,000 will buy far less shares than you thought reducing your investment yield to 9%, the same as you were getting from the bank.

OK I am simplifying things a bit here. The market does price in risk. An investment in Telecom is seen as riskier than a term deposit. So that means you will get slightly more by way of a Telecom dividend than from interest by investing in the bank. But the point I am making is that the amount 'extra' that you get is actually quite small. You won't get a return of 26% just by buying Telecom shares on market!

Other thing I am not sure about is the dividends. How do I go about including dividends in the formula?

Ah now there is an important question, and there is no one answer.

There is a school of thought that dividends are a bad thing. Why? Because any money paid out in dividends *reduces* shareholder equity. The lower the shareholder equity, for a given ROE, the lower your return is likely to be. That's because:

Total Return= (Shareholder Equity)x(ROE)

And, for a constant ROE, reducing shareholder equity will reduce your return in the future- not a good thing

Either the company will keep the money they earn OR distribute it to you as dividends. But they can't use the same money to pay you a dividend AND build up shareholder equity. The company management has to *choose* what they will do.

If a company can earn a superior return on the equity they retain from normal earnings, than you can get by investing that same money, then (in theory) you do not want them to pay a dividend. But if they can't do that, then paying you the money as a dividend is the best use of the cash they are generating.

SNOOPY