Question

Return on equity, or ROE, is a measure of a company’s efficiency at generating profits using the shareholders’ stake of equity in the business according to one of this week’s readings (see DuPont Ratio, ROE, ROA and Growth). ROE is based on the book value of equity, yet many say that the book value is less important than the market value of equity. Should management bonuses be based on ROE? What are the pros and cons of such a compensation system? What are the advantages of a firm focusing on ROE, particularly with respect to its analysis using the DuPont equation? Does a focus on ROE promote firm growth, why or why not?

Please explain your answer with at at least 250words.

Answer 1

• ROE is the return that company is able to generate for its equity shareholders on invested capital.
• Yes, the management compensation can be based on ROE because equity motivates the employees. The reason behind giving equity is to make the people feel like owners.
• Pros and Cons of compensation system : The employees will get big picture, use good picture and keeps company bests interest foremost. and on the other side the people doesn't have any idea about stocks and its value.
• DuPont analysis provides a broader picture of return the company is earning on its equity. It tells where a company' s strength lies and where there is a room for improvement.
• The growth depends on whether the increase in ROE is based how the ROE is increasing i.e due to increase in net profit margin or asset turnover ratio or due to leverage. In these cases if the increase is only due to financial leverage then it is risky, since the company is increasing the assets by taking debts.