Return on Equity

For any investment decision whether it be the purchase of a four-plex or the launch of a small business, it is important to have the ability to calculate the investment’s return on investment and return on equity. Return on investment is found simply by dividing the business’s earnings by the initial investment whereas return on equity is the earnings divided by the equity in the business found on the balance sheet. These ratios are crucial for investment purposes.

For example: Your business, a hamburger stand, consistently generates $10,000 a year in earnings on an initial $50,000 investment for a return on investment of 20%. A second location will generate $1,000 a year in earnings on a $25,000 investment for a 4% rate of return. A quick Google search reveals that risk-free T-bills are paying approximately 4.7%, a return slightly higher than the 4% second location. The optimal investment decision would be to take the T-bills and not the second location. If you discover another expansion opportunity yielding a return greater than or equal to 20% though, all things equal, it would be financially prudent to pursue the new opportunity.

Rate of return can be used to compare within and across asset classes as well. For example: a dividend paying stock yields a 7% rate of return for the year is inferior to a rental property investment returning 15% a year, all else equal. A duplex cash flowing at $5,000 a year on a $50,000 investment is providing a 10% rate of return, a superior investment when compared to a duplex cash flowing at $2,500 a year on a $50,000 investment for a 2.5% yield.

A stock consistently delivering an average 20% return on equity, in Warren Buffet’s opinion, is delivering a 20% rate of return. A dividend stock paying an annual yield of $.70 with an average price of $10 a share is paying a 7% rate of return. A business with $20,000 in earnings for the year and an initial investment of $100,000 is yielding 20%.

In the world of small business and investing, rate of return reigns supreme.