Question

Clearly define Return on Equity' (ROE); how does it differ from 'Return on Assets (ROA)'? In addition, why are market participants interested in calculating a company's P/E ratio before making investment decisions ?

Answer 1

• Return on equity (ROE) measures how effectively management is using a company’s assets to create profits. ROE is expressed as a percentage and can be calculated for any company if net income and equity are both positive numbers.
• The difference between ROE and ROA is financial leverage or debt. We can clarify this difference from the equations of ROE and ROA.     

ROE =NET INCOME / SHARE HOLDERS EQUITY Where                                                                                                       SHARE HOLDERS EQUITY = ASSET-LIABILITIES                                

ROA = NET INCOME / TOTAL ASSETS

As per accounting equation TOTAL ASSET = SHARE HOLDERS EQUITY + LIABILITY

· P/E RATIO

the P/E ratio shows what the market is willing to pay today for a stock based on its past or future earnings. The P/E ratio is important because it provides a measuring stick for comparing whether a stock is overvalued or undervalued. A high P/E ratio could mean that a stock's price is expensive relative to earnings and possibly overvalued. Conversely, a low P/E ratio might indicate that the current stock price is cheap relative to earnings.