The S&P 500 index firms are those firms which are maintained and managed by the poor. These are firms which have been listed in the United States of American and they comprise 75% of all the firms in the country.
Firm's return on equity - this is used to measure shareholders’ return on a given common stock. It is used to measure how a firm is efficient in generating profits / returns from ownership interest / shareholders equity (also commonly known as asset – liabilities / net assets of a given firm). Return on equity is used to show how effectively and efficiently a firm generates income growth from various investment funds. The most desirable return on equity is usually the one that ranges between 15-20 percent.
Return on equity is mainly used to compare the performance of various firms which are operating within the same industry. Higher return on equity usually yields no benefits immediately. They fail to yield immediate benefits due to their stock / share prices are mainly determined by use of Earnings per stock (EPS) (Federal Register, 1990). For example, one will be paying much higher price for share which have 20% REO compared to those with 10% REO. One may end up paying twice for the one with 20%. Return on equity is calculated using:
ROE=Net profit / income after tax / shareholder's equity given our firm which has total assets worth $ 10 million and total debt of $ 6million plus an net profit / income of $ 600,000. Return on equity will be,
Shareholders equity = total assets - debt $16,000,000 = $10,000,000 + $ 6,000,000
Net income = $ 600,000
REO = ($ 600,000 / $ 16,000,000) 100%
The percent return on equity of the firm is undesirables as it falls much below the desirable REO of in between 15 to 20 percent. Thus the firm’s return is much below the required rate of return that one can desire. It seems that the firm's net income is insufficient to pay back owners of common stock / shareholders equity. The income being generated by the firm is much below what shareholders have invested (American Society of Appraisers, 2005). It can be concluded that the firm is inefficient and infective in managing shareholders equity.
The above percent return on equity has the following implications to the firm. The sustainable growth of the firm will be affected. The firm cannot manage to do without issuing more equity and this will tend to go contrary to the model of sustainable growth which is of the following assumptions:
(i) A firm needs to maintain a given / particular capital structure without necessarily issuing any new equity (ii). Dividend payment ratio should be within a given target. Our firm in question will not achieve sustainable growth because the above conditions have not been fully met. On the other hand, the dividend payouts will be negatively affected – the amount of dividend that the firm can give to the stock owners who have invested their funds with an objective of getting returns informs of dividends will be very low compared to what they have invested in the firm (Woolridge, 2006).
In addition, negative image among new investors. The firm’s image will be negatively affected because new investors will not have confidence in investing their funds in the firm. This will result to the failure of the firm to get enough funds for expansion if it issues new stock, due to under description.
The firm’s management should come with ways to ensure that return on equity is within the desirable levels in order to avoid negative implications that come on return on equity being within undesirable levels. The firm should come with means of improving its net income after tax so that it can have desirable dividends which will create confidence among current and future investors.