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Return on Net Worth Definition
Return on Net Worth is a ratio developed from the perspective of the investor and not the company. By looking at this, the investor sees if the entire net profit was passed on to him, how much return would he be getting. It explains the efficiency of the shareholders’ capital to generate profit.
Return on Net Worth Formula
Return on Net Worth (RONW) is a measure of the profitability of a company expressed in percentage. We calculate it by dividing the net income of the firm in question by shareholders’ equity. The net income used is for the past 12 months. Mathematically, it represents as follows:
RONW = Net Income / Shareholders’ Equity
RONW = 100,000 / 500,000 = 0.2 or 20%
For example, let’s assume that ABC Inc. posted a net income of $100,000 in the past year. At the same time, the value of shareholders’ equity was $500,000, then the RONW would be:
The net income should be of the past year and the equity should be as of the end of the period for which we are calculating return on net worth. Also, the equity should be adjusted for stock splits and should not include preferred shares.
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In other words, return on net worth indicates how much profit has been generated for every dollar of equity investment. Even more plainly, it is a measure of how well the company is utilizing the money invested by shareholders. In accounting terms, the example given above shows that for every dollar of equity in ‘books’, ABC Inc. generated a 20 cent return.
A high RONW percentage is indicative of the prudent use of shareholders’ money while a low percentage indicates less efficient deployment of equity resources.
RONW is a vote of the efficiency of a company’s management. Here, an increasing percentage indicates higher efficiency in generating profit on every dollar of investment.
Interpretation of RONW
For studying this measure, it is important to look at it over several periods of time in order to assess whether the company has been more or less efficient in generating profits on shareholders’ equity over the years.
Also, an increasing RONW may result from a decline in the value of shareholders’ equity. Hence, a share buyback can artificially increase return on equity from which investors and analysts may draw an incorrect conclusion of higher profits or increased efficiency. Hence, it is important to look at the ratio in its entirety before drawing conclusions about the firm under analysis.
Combined with return on assets (ROA), return on net worth can show whether leverage is being employed by a company. For instance, if ROE is greater than ROA for the same period. It is a sign of using leverage to increase profits because higher debt means fewer requirements for equity, which will boost ROE.
When comparing different companies in terms of their RONW, it is important to ensure that the companies are comparable in terms of the business cycle as well as industry else the measure may not be useful.
For instance, a comparison of RONW of a company from the technology and another from the utility sector may not give the right picture as technology companies tend to have lower debt while utility companies usually have high levels of debt. Also, technology companies are usually higher growth companies while utilities are usually stable businesses, thus making a comparison between the ROE of these two companies incorrect.1,2