The goal of any investor is to make as much profit as possible while taking on the lowest amount of risk. In this regard, both return on equity and rate of return can help investors compare different opportunities and choose the ones that are most likely to be lucrative.
Return on equityReturn on equity, or ROE, is a measure of how much profit a company is able to generate with each dollar of shareholders' equity it receives. Return on equity offers great insight as to how investor dollars are being used.
Return on equity can be calculated by taking a company's net income and dividing it by shareholders' equity. Let's say a company generates $5 in net income over the course of a year, and that its shareholders' equity during that time totaled $10 million. In this case, the return on equity would be 50% ($5 million/$10 million). What this means is that the company in question generated $0.50 of profit for every shareholder dollar invested.
While ROE is a good measure of profit, it also shows how efficiently a company manages the money it receives from shareholders. If a company's ROE rises continuously, it's a sign that its management has found ways to bring in profits without needing as much capital moving forward. On the other hand, if a company's ROE starts falling, it could be a sign of financial mismanagement. Comparing the ROE of similar companies can help investors decide which constitute the smartest investment choices.
Rate of returnA rate of return is the gain or loss on an investment over a specified period of time. Rate of return can be applied to a wide range of investments, from stocks to bonds to mutual funds. Investors often rely on rate of return when deciding where to put their money, and the higher a company's historic and recent rate of return, the more enticing an investment it might be.
Rate of return is calculated by taking the difference between the final value of the investment at the end of the period in question and the initial value, and then dividing that figure by the initial value. Let's say you invest $20,000 in stocks at the start of the year, and that your portfolio is worth $25,000 by the end of the year. In this case, your rate of return would be 25% ($25,000-$20,000/$20,000).
Riskier investments tend to offer higher rates of return than those that are less risky because investors need to be compensated for taking on additional risk. Stocks, for example, are generally considered riskier than bonds, and as such, they've historically delivered higher returns to investors than bonds have.
DifferencesWhile rate of return tells you how much profit you've made, or how much others have made, from a specific investment over a certain period of time, return on equity is a calculation specific to stocks that calculates how much money is made based on shareholders' investment in a company. While rate of return shows you how profitable your investment in a company has been, unlike ROE, it doesn't offer the same insight as to how effectively that company is using your money to generate profits.
This article is part of The Motley Fool's Knowledge Center, which was created based on the collected wisdom of a fantastic community of investors. We'd love to hear your questions, thoughts, and opinions on the Knowledge Center in general or this page in particular. Your input will help us help the world invest, better! Email us email@example.com. Thanks -- and Fool on!
The article What Is the Difference Between Return on Equity and Rate of Return? originally appeared on Fool.com.
Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.
Copyright 1995 - 2016 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.