Rate of return and return on equity both enable investors to compare various companies when choosing where to invest. However, the rate of return is more commonly used to calculate whether the expense of investing in a new fixed asset is worth the expected return. Rate of return is commonly used by company decision-makers when determining whether to invest in capital, while return on equity is more commonly used by private investors when determining whether to invest in a particular company.
Rate of Return
Rate of return is more commonly referred to as return on investment, or ROI. According to the online business dictionary, ROI is “is a measure of profitability that indicates whether or not a company is using its resources in an efficient manner.” While return on equity is used exclusively for measuring equity performance, the rate of return may be used to measure several aspects of a firm’s performance. Rate of return provides a concrete measure of the efficiency of a capital investment.
According to the Oracle ThinkQuest website, the rate of return, or return on investment, is typically calculated using the equation, ((Return - Capital) / Capital) × 100% = Rate of Return. The rate of return may be calculated based on a variety of investments, including investments the company makes in fixed assets such as buildings or equipment. The rate of return may be influenced by a variety of factors, including labor and fuel costs. Because of the influence of such uncontrollable variable costs, the rate of return may not provide a direct reflection of management efficiency.
Return on Equity
According to economist and author Gene Siciliano, in his 2003 textbook, “Finance for the Non-Financial Manager,” return on equity refers to the rate at which the investor may expect to see a return on his cumulative investment in the corporation. Private investors typically expect to see a positive ROE on their investments and make investment decisions based on the ROE of various investment opportunities. For example, an investor may be more likely to invest in a fund that provides an expected rate of return of 20 percent than in one that provides an expected rate of return of 5 percent, assuming the risks of each are equal.
The return on equity ratio measures the percentage that shareholders earn in return for their investment in the corporation. Return on equity is calculated by dividing annualized net income by stockholders' equity. According to Siciliano, return on equity “serves as a measure of a company’s earning power.”
- Google Books; Finance for the non-financial manager; Gene Siciliano; 2003; p. 111
- Business Dictionary: Rate of Return
- Business Dictionary: Return on Investment (ROI)
- Tutor2u; A2 Macroeconomics/International Economy - Capital Investment & Spending; Geoff Riley; September 2006
- Oracle ThinkQuest: Calculating the Rate of Return on Investments
- Thinkstock/Comstock/Getty Images