Unlevered Return on Equity Vs. Levered Return on Equity

by Tim Plaehn
Return on equity is a measure of profitability that can be boosted with borrowed money.

Return on equity is a measure of profitability that can be boosted with borrowed money.

Return on equity is a financial metric that shows how much money a company earns on its invested capital -- the equity. The equity can be leveraged by borrowing money to increase the size of a business or the amount of investments a company can purchase. You will typically see and be able to analyze results from return on equity, and leveraged return on equity, with companies involved in some sort of financial endeavors. You may also use leveraged and leveraged results as measurements for your own investment returns.

Return on Equity

Return on equity is the gain, business net income, or percentage earnings yield on invested capital. For a simple example, a business is started with $50,000 of paid-in owner or shareholder capital, and ends up the year with a $5,000 profit. Dividing the profit by invested equity produces a 10-percent return on equity. For both businesses and investments, it is difficult to produce a return or profit without putting in some money, which becomes the capital invested, or equity. For a publicly traded company, the results will be reported as a return on shareholder equity.

Borrowing For Leverage

To obtain additional capital to fund business operations, a company may choose to borrow money to increase the amount invested in the company. The borrowed money is used to increase the profits or earnings from the operations, either as a business or through investments. Consider an example company that borrows $50,000 on top of the $50,000 of equity. With the larger capital base the company then earns $8,000 in profits. The result would be an 8-percent return if $100,000 was invested unleveraged. In this case, the $8,000 results in a 16-percent leveraged return on the original equity.

Costs of Leverage

While leverage can boost the returns from a business or investment, there are always costs attached to borrowed money. Of major importance is the rate paid to borrow. If the business cannot earn more than the interest rate using the borrowed capital, there will not be a leverage of results on equity. Also, lenders will put restrictions on how much you can borrow depending on the amount of equity in the business and the type of business or investment. As examples, real estate investment trust companies that invest in government-backed mortgage bonds can leverage equity 7 or 8 times or higher. For a more industrial type of business, a financing combination of equal parts equity and debt may provide a safe level of leverage and attractive returns.

Necessity of Business

Often for a business to earn the type of profit that results in an acceptable return on equity, leverage is required. Real estate investment trusts, called REITs, are a good example. If one of these REITs purchased mortgage securities using only equity, the investments would pay about 3 percent -- 2013 rates -- and investors get about 2 percent after expenses. When a mortgage REIT is able to borrow 6 or 7 times it equity and use that money to buy a lot more mortgage bonds, the REIT is able to pay dividend yields to investors that often top 10 percent.

About the Author

Tim Plaehn has been writing financial, investment and trading articles and blogs since 2007. His work has appeared online at Seeking Alpha, Marketwatch.com and various other websites. Plaehn has a bachelor's degree in mathematics from the U.S. Air Force Academy.

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