TheStockAdvisor Advice

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:

  1. Look at the previous annual statement
  2. Use the four most recent quarterly reports
  3. If less the four quarters are available, annualize the available reports
  4. Average a series annual reports

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 represents a sound investment, where investors will see a substantial payback. For example, if there is a ROE of 25% then $.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 maintain operations.

Take a closer look at the calculation of ROE and see how it incorporates the profitability, asset management and financial leverage of a company.

  1. Profitability 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.
  2. Asset 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.
  3. Financial 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:

One Year's Earnings divided by Shareholder's Equity,

which is Return on Equity.

These three factors are what managing a company is all about. Those who successfully juggle these realize a high ROE, distributing earnings to investors. 


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