There are lots of ways to measure the financial returns that can affect a shareholder's investment. Return on equity is the simplest yardstick, as it shows the total amount that shareholders get as a class on their original stock purchases. Internal rate of return is more complicated, but it will tell you what the annual growth rate of your investment is over time.
While return on equity shows how profitable a company is in relation to its shareholders' equity, the internal rate of return gives a picture of the time value of the money invested.
Return on Equity Defined
Return on equity measures a company's profitability in relation to shareholders' equity. This gives vital clues about how well the shareholders' cash is being used and how efficiently the company is being run. For investors, return on equity is perhaps the most important metric for evaluating management performance. It is especially valuable when comparing one company to its competitors, since return on equity gives an accurate representation of which companies are operating with greater financial efficiency. You can also track return on equity over different accounting periods. This will tell you whether management are performing better or worse than previous years.
Internal Rate of Return Defined
Internal rate of return is a bit more complicated because it's more of a concept than a mathematical formula. The easiest way to explain it by using an example: If your brother offered you $1,000 but you have to wait 12 months to receive it, how much would you pay right now to receive that $1,000 in a year? What you're looking for here is the net present value, or today's equivalent, of a guaranteed $1,000 in 12 months' time. You calculate this by estimating the discount rate, which essentially is a reverse interest rate. So, if you apply a 10 percent discount rate, $1,000 in one year would be worth $909.09 today.
The idea behind internal rate of return is to identify the discount rate that makes the net present value of cash flows equal to zero. This tells you what the annual "smoothed" growth rate is for your investment over a specified period, even if that period is far into the future. If the internal rate of return of a potential investment exceeds your required rate of return, that investment clearly is desirable.
Importance in Choosing Investments
The return on equity and internal rate of return are very different, but they both are useful metrics for sizing up the strength of a potential investment. However, while return on equity is beautiful in its simplicity – you calculate it by dividing net income by shareholder equity – it doesn't tell you anything about the actual return you can expect to receive on your stock purchase. For that, you need the internal rate of return. The internal rate of return lets you compare the returns you are getting from your investments against stock purchases you could have made, or against the returns of an index fund. If the stock market rose by an annualized 10 percent, for example, and your stock achieved an internal rate of return of 12 percent over the same period, then this can inform a decision to direct more cash to that investment.
Relative Versus Absolute Numbers
Where the internal rate of return falls short, is that it does not measure the absolute return you're getting on your investment. A $10 investment returning $30, for example, has a higher internal rate of return than a $1 million investment returning $2 million. Relying on the internal rate of return alone can skew your decision-making toward stocks with high rates of return even if the dollar amount you're achieving is relatively small. The return on equity, on the other hand, is an absolute number. Divide the company's net income from the income statement by the shareholders' equity on the balance sheet, and you'll get a percentage that shows how much profit was generated from the company's equity financing. The higher the return on equity, the more efficient a company is at generating income and growth.
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Jayne Thompson earned an LLB in Law and Business Administration from the University of Birmingham and an LLM in International Law from the University of East London. She practiced in various “big law” firms before launching a career as a commercial writer. Her work has appeared on numerous financial blogs including Wealth Soup and Synchrony. Find her at www.whiterosecopywriting.com.