Calculating Interest 7: ROI vs ROE

Most of this series has been on calculating your Return on Investment or ROI. You take your initial investment and use simple interest, compound interest, the rule of 72, average return, IRR, cash-on-cash, etc., to determine an ROI. But ROI doesn’t help you know when you should cash out of your investment.

For example, you invest $10K and it’s worth $20K after the first year. That’s 100% IRR. That’s good. But is it still good if it only earns you $100 each year after that for 4 years? Year 1 you have $20K which 100% IRR. Year 2 is $20,100 and 41.77%. Year 3 is $20,200 and 26.41%. Year 4 is $20,300 and 19.36%. Year 5 is $20,400 and 15.33%.

If you didn’t track this over time and only looked and the Year 5 IRR, you might think 15% isn’t too bad. But if you looked at it over time, you’d see that your greatest return was in Year 1.

Return on Equity or ROE can make this more obvious. Instead of always using your initial investment to calculate your return, ROE uses your current equity.

Using ROE for the above example, Year 1 grew from $10K to $20K, so it’s still 100% IRR. Year 2’s equity, however, only grew from $20K to $20,100, which is only 0.5% IRR—yes, that’s less than one percent. Year 3 grew from $20,100 to $20,200, which is still only around 0.5% IRR. The return is around 0.5% IRR again for Year 4. And Year 5 drops down to 0.49%.

ROE shows that you should’ve cashed out after Year 1 and invested somewhere else.

What do you think?
Joseph

This is a series. Here is the previous post.