Return on Equity
When looking for a company to invest in, what
should you look for? One easy to calculate tool is Return on Equity (ROE).
ROE looks at the profitability, asset management and financial leverage of a
company. Considering this, ROE helps the investor evaluate the type of
return expected, as well as management’s ability to run a company.
ROE is calculated by taking a year's worth of
earnings and dividing them by the average shareholder's equity for that
year. You can find earnings from a company’s SEC filings. There are many
methods of coming up with annual average:
- Look at the previous
- Use the four most
recent quarterly reports
- If less the four
quarters are available, annualize the available reports
- Average a series
Try to select the method which best fits the
company you are looking at. Are they a new company or have they been around
for many years? Has their business model significantly changed recently? Are
they a seasonal business? All of these should be taken into account when
determining the annual earnings.
Shareholder’s equity can be found on the
balance sheet and is simply the difference between the total assets and
total liabilities. This represents the assets that have actually been
generated by the business. A high shareholder’s equity usually represents
a sound investment, where investors could see a substantial payback. For
example, if there is a ROE of 25% then $0.25 of assets are generated for
each dollar invested.
The ROE allows you to quickly determine if a
company will generate assets or just continue to seek investment dollars to
Let's take a closer look at the calculation
of ROE and see how it incorporates the profitability, asset management and
financial leverage of a company.
can be determined by dividing one year’s earnings by one year’s
sales. Profit margin is the amount remaining after paying all of the
costs of running the business. Management that increases profit margins
is controlling costs either by squeezing efficiencies out of the
business or cutting out unprofitable ventures. Although management can
cut costs too far – bleeding out necessary research and development
spending, for instance -- for the purposes of analyzing the ROE
generated by a business, a higher profit margin means a higher ROE.
management can be determined by dividing one
year’s sales by assets. Asset management is probably one of the
factors individual investors have the most difficulty using to evaluate
a company. Certainly you can compare various asset management ratios for
companies within an industry. How can you tell if so much in sales per
dollar of total assets is good or not so good for a given company on
more than just a relative basis? Looking at asset management in the
context of the total ROE allows the investor to balance a company's
asset management ability with its profit margins and the financial
leverage employed in order to discern whether the actual business is
great or simply mediocre.
leverage can be determined by dividing assets by
shareholder’s equity. A lot of people want you to believe that
financial leverage (debt) is no good. Most of those people apparently
buy everything with cash. For the rest of the world, debt is much like
anything else -- okay in moderation, but overdoing it is not a good
idea. As anyone who has ever had a high credit card balance can attest,
debt tends to feed on itself, growing to enormous proportions with very
little food and watering. When a company takes on debt, it increases the
total amount of capital it has at its disposal to finance whatever it is
it wanted to finance in the first place. Unlike equity, debt carries a
direct cost called "interest" that eats away at a business's
profitability. Sure, if you take on $500 million in debt you can
suddenly produce 1,200 more widgets a day. However, your profit margins
on the extra widgets plummet to 5% from 10% because the interest on the
debt costs you 5%, meaning that the additional gain becomes incremental.
If you multiply the formulas for
profitability, asset management and financial leverage you are left with:
Earnings divided by Shareholder's Equity,
which is Return
These three factors are what managing a
company is all about. Those who successfully juggle these realize a high
ROE, distributing earnings to investors.