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Finance a la shmoop What is r o e or

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a return on equity when you go to a fancy

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sushi bar while those little orange eggs cost a small

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fortune they come from libertarian salmon and tastes like assault

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licked from your grandmother's purse So that's row but well

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has nothing to do with this kind of row or

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return on equity Different thing Alright so very simply Anytime

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you see a ratio that's return on anything It means

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profits in the numerator Sitting on something in the denominator

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like return on sales is a company's profit margin right

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You have profits divided by sales and well that's Pretty

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easy calculation to make if you have the data so

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return on equity Well that's a little bit different in

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that finding What you mean by equity is sometimes a

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bit of a moving target or a religious discussion in

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the way the equity line on the balance sheet was

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in fact calculated In essence the equity value of a

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company is what it owns over time Like it accumulates

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equity profits in the brand equity and patents and a

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whole bunch of other crap And it owns all that

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Got it it's The equity value of the firm like

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the cash profits is generated over a long period of

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time with the cash it's received from investors plus fair

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value of all the patents and brands and distribution infrastructure

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and eighteen zillion other elements that all add up together

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when you subtract liabilities from assets to get that either

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that's the yeah they all come together to comprise whatever

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number is placed as the equity of the firm So

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if you go back to our friendly little lemonade stand

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with twelve grand in profits or returns and equity of

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thirty six grand then it's row is yes one third

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or thirty three percent Well is that good Bad ugly

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Well in a vacuum we don't really know Because each

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industry command such different kinds of numbers when it comes

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to the efficient use of its equity a lemonade stand

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needs well relatively very little capital expenditure to get started

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It should have very high returns from its equity because

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its profit margin should be very high When it's selling

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for a dollar something that costs a dime you can

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think of that thirty three percent return on equity as

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being something that might map to investing in a stock

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market reflective index fund and yes thirty three percent a

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year return from any kind of stock market investment Overtime

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is heroic The problem While the return number is likely

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highly volatile in a company with such massive return on

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equity that is yes So this year our little lemonade

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stand made twelve grand But next year it might lose

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five the following year make twenty and then the following

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year well goes bankrupt So the r o e number

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for a company is so fragile what's on the edge

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of meaningless really compare the row for a large oil

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company Well oil is massively less volatile as an industry

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That is our little lemonade stand and oils One of

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the more volatile industries just light A match there happened

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and twenty billion dollars well just buys you a well

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some storage tanks a little distribution infrastructure and hopefully a

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decent line Teo getting your money back eventually So if

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you measure the return on equity of a big oil

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company over a ten year cycle well you might find

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that return is only four and a half percent Well

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That equity could have been deployed almost certainly in the

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investing community like an index finding factor whatever and done

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much better than what the managers of the oil company

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did in putting all that money in the ground through

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wells and exploration and refining and so on So is

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an unschooled investor You might begin to be leaning on

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management to take their cash and do something else with

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it Like how about investing it in an internet search

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company Yeah we need another one of those You know

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those google people had really high r o e let's

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do more of that And then one day a bomb

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goes off in the middle east Big one Oil prices

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go from fifty bucks a barrel to one hundred And

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for the following decade the r o e of the

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oil company looks a lot more like that Thirty three

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percent fromthe lemonade company And the investor who pushed shell

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to fund a google competitors goes back to work making

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fives and tens and change at bank of america and

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pushing customers to you know refinance their more Well the

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bottom line is that are we is a moving target

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At best and only exists in the vague never land

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of time And that contextually It only means something when

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mapped against the whole host of other things that players

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could do with their money So if you're companies trying

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to stay above water and you start smelling something fishy 00:04:16.772 --> [endTime] well you know it might just be the row

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