Course 205: Measuring Returns on Capital
Why Return on Equity Matters
In this course
1 Introduction
2 Return on Equity
3 Why Return on Equity Matters
4 ROE and Internet Stocks

Let's go back to the restaurant example. Instead of just one sci-fi restaurant, let's say you want to open a whole chain of them. In the early years of building your empire, you'll be adding to your capital base aggressively. But because of the costs of opening restaurants, you will probably take losses; most companies in their formative stages lose money. If after a few years you've sunk $500,000 into your restaurants but are losing $50,000 annually, your return on capital is negative 10%. (A pretty realistic figure for the sci-fi idea, I'd say.) It's not necessarily bad for a company to earn a negative return on equity--if it can earn a high return in the future, that is. An investor will stomach a negative 10% ROE for your sci-fi restaurants if he believes they can earn much higher returns in the future. The trouble is, in a company's rapid-growth phase, when returns on equity are most often small or negative, it's tough to separate a good business (one that can earn a high ROE) from a bad business (one not able to). After all, each is losing money. Analyzing such companies means asking questions like "Is this a company with enough pricing power to eventually command a premium price for its product?" And "Is this a company with enough of a cost advantage that it can undercut the competition?" It means, in other words, asking whether the company's business can either generate a high net margin (profit/sales) or a high asset turnover (sales/assets), the two key components of a high return on capital.

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