Deciding whether to invest in a company requires some due diligence. One key measure of company performance is its return on equity (ROE).
The return on equity formula is fairly simple: investors can divide a company’s net income by average shareholder equity. Shareholder equity is arrived at by subtracting a company’s debt from its assets.
Thus, ROE can be considered a measure of performance as well as a company’s return on its net assets. As such it can be viewed as a measure of profitability and how efficiently a company generates a profit (assuming it does).
Key Points
• Knowing a company’s return on equity, or ROE, can give investors insight into company performance.
• Return on equity can be determined by dividing a company’s net income by average shareholder equity for a certain time period, assuming both are positive.
• ROE is a ratio expressed as a percentage.
• To calculate shareholder equity, subtract a company’s debt, including dividends, from its assets.
• ROE can help investors assess not only a company’s performance, but how efficiently it generates profits.
The Return on Equity Formula
The formula for return on equity is a fairly straightforward calculation that can provide a key comparative metric to investors. Here it is:
Return on Equity = Net Income/Average Shareholder Equity
The ROE ratio helps to determine how well a particular company is managing shareholder investment. The higher the number, the more efficiently the company’s management is likely generating growth from the money invested.
Investors can then compare the result for one company to the ratio of another company, and so forth.
How to Use the ROE Formula
Before you buy stocks online or through a traditional brokerage, using the ROE formula can be helpful. Calculating return on equity requires two pieces of information: net income and shareholder equity.
• The difference between a company’s net revenue and its total expenses, including interest and taxes, is its net income.
• Shareholder equity is typically found on a company’s balance sheet, and for the purposes of calculating the ROE it’s generally the average of the shareholder equity at the beginning and end of the period being analyzed.
Publicly traded companies are legally required to distribute income statements in their annual financial reports to shareholders where this information can be found. Net income, also called “net earnings” or the company’s “bottom line,” is a figure that’s included on a company’s income statement, also called a P&L statement or profit and loss statement.
Understanding Net Income
Net income is calculated by taking the amount of a company’s sales and then subtracting what’s called the “cost of goods sold” from the figure.
Cost of goods sold, in turn, is calculated by determining the direct costs of making products, which includes the cost of materials used and direct labor costs. It does not include indirect costs, such as marketing.
Subtract the costs of goods sold from the sales total — and then also subtract operating expenses, administrative expenses, taxes, depreciation, and so forth. What’s left is a company’s net income.
Understanding Shareholder Equity
This information can be found on a company’s balance sheet, and the formula for shareholders’ equity is as follows: total assets minus total liabilities = SE. In other words, it’s what a company owns minus what it owes.
As another way to look at this, if all of a company’s assets (buildings, equipment, investments, and so forth) were liquidated into cash and all debts were paid off, what remained would be shareholder equity.
How to Use Return on Equity Ratios to Invest
How can you make use of ROE ratios when investing? If a company has $5 million in net income, with shareholder equity of $25 million, then return on equity can be calculated in this way: $5,000,000/$25,000,000 = 20%.
An investor can then use this ratio to compare stock in one company versus those available from another company in the same industry or sector.
When calculating the ROE ratio, an investor gains visibility into a moment in time. Investors may choose to do that before buying or selling shares — or they may track the performance of a stock over a period of time.
Insights When Using Return on Equity
In general, when ROE rises, it means the company is generating profit without needing as much capital. It demonstrates that the company is efficiently using the capital invested in the business by shareholders. When the ratio goes down, it is generally a sign of a problem.
This, however, is not universally true. There are times when return on equity artificially goes up. This can happen if a company buys back shares of its own stock or if the company has a significant amount of debt. So, although ROE is a key metric for investors to use when deciding if a particular stock is a worthwhile investment for them, it’s not a stand-alone metric.
Here are a few additional factors to consider. Because some industries as a whole typically have higher ROE ratios than others, comparisons between companies are more meaningful when done between two companies of the same industry.
Plus, in general, the more risks taken in investment choices, the higher the potential for return, as well as for loss. So, some investors with a higher tolerance for risk may choose to buy shares of stock in companies that don’t look as desirable if they have reason to believe that there is enough potential for significant financial rewards.
What Else to Consider with ROE
When buying shares of stock, an investor is buying ownership shares of the company. So, when the company does well, the stockholders typically benefit. When all goes south, the stockholders usually lose out.
This means that, when an investor knows a reasonable amount of information about the company and the industry it’s in, as well as its financial structure, better investment choices can typically be made. Other factors that influence the investor during the decision-making process include the economy, customer profiles of a business, and more.
To glean these types of insights, investors often look at financial reports, in addition to return on equity, when choosing how and where to invest.
Experienced investors will often take their time reviewing documents of companies that interest them, such as the financial reports that the Securities and Exchange Commission (SEC) requires public companies to file. Many of these need to be filed quarterly, and they can provide insights into companies’ financial performance.
Here is an overview of important information that can be found in the different types of financial documents:
• Income statement: This document provides an overview of a company’s revenue (cash coming in), expenses of significance (cash going out), and the bottom line (the difference between what’s coming in and what’s going out). Consider what trends exist.
• Balance sheet: Look at the company’s debt (how much they owe). Is the amount going up or down? In what ways? Consider what can be learned about the company’s financial performance from this review.
• Cash flow statement: What did the company actually get paid in a particular quarter? This is different from what’s owed (accounts receivable) and instead focuses on when the cash arrives to the company. Does the company have steady cash flow?
Investors typically look at a company’s after-tax income (its “earnings”), which can be found in quarterly and annual financial statements. In addition to looking at the company’s current earnings, it can make sense to review its history to see how much earnings have fluctuated and whether there’s a pattern to these fluctuations. Overall, good earnings indicate a company is profitable and may be a good investment to consider.
Another figure to consider reviewing is a company’s operating margins (also known as its “return on sales”). This indicates how much a company actually makes for each dollar of its sales. This calculation involves taking the company’s operating profit and dividing it by net sales. Higher margins are typically better and may indicate good financial management.
Now, here are other financial ratios to consider, besides the return on equity ratio:
• Price-to-earnings ratio: This allows investors to compare stock prices between companies offering shares. To calculate this ratio, take the market price of a share of stock and divide that number by the amount of earnings that a company is paying per share. This ratio allows investors to see how many years a company may need to generate enough value for a stock buy-back.
• Price-to-sales ratio: This can be a good metric to use when reviewing a company that hasn’t made much of a profit yet — or one that’s made no profit at all, so far. To calculate this, take the value of the company’s outstanding stock in dollars and divide that number by the company’s revenue. The resulting figure, ideally, should be as close to one as possible. If the number is even lower, this is an outstanding sign.
• Earnings per share: This metric helps investors to know how much money they might receive if the company liquidates. So, if this number is consistently going up, this may entice more people to buy shares because this at least suggests they’d get more for their investment dollars if liquidation happened.
Earnings per share can be calculated by taking the company’s net income and subtracting a certain type of dividends (preferred stock), and then taking that figure and dividing it by the number of outstanding common stock shares. Preferred stocks don’t have voting rights attached to them like common stocks do, but they receive a preferential status when earnings are paid out.
• Debt-to-equity: Investors use this metric to try to determine the degree that a company is using debt to pay for its operations. To calculate this figure, take the company’s total liabilities and then divide that number by the total shareholder equity. A high ratio indicates that the company is borrowing to a significant degree.
• Debt-to-asset ratio: Investors may decide to compare debts to assets of a company — and then compare the resulting ratio with other similar companies to determine how significant a debt load a company has. It may be wise to calculate this within the context of a particular industry.
What Is a Good Rate of Return?
First, consider that, when cash is kept under the mattress at home, the rate of return is zero percent. And, when factoring in inflation, this means the person is actually losing money over time. Keeping money in a checking account can amount to virtually the same thing.
There is no guaranteed return on investment in stocks. That’s because of variations in the market, varying degrees of risk taken by investors, and so forth. There are, however, historical precedents that indicate how stock ownership over the long haul can often allow the investor to weather economic fluctuations for an ultimately positive result. And, when looking at the average annual return of the stock market since 1926, that number has been about 9%, although it’s closer to 6% or 7% when inflation is factored in.
Another relevant topic is risk tolerance. This is the amount of risk that a particular investor is comfortable taking when choosing securities — here’s a quiz to help investors determine their risk tolerance. By knowing your risk tolerance, you’ll have a better idea of the amount of risk you’re comfortable with, and the potential range of investing returns that you might expect from the investments you pick.
Things to consider when determining how much risk to take include:
• Financial factors: How much could you afford to lose without it having a negative impact on your financial security? When people are young, they typically have much more time to recover from a big market loss, so they may decide it’s okay to be more aggressive.
People closer to retirement age, though, may decide to be more protective of their assets. It’s important to review current financial obligations, from mortgage payments to college tuition, to make an informed decision, as well.
• Emotional risk: Some people feel energized when taking risks while others feel stressed. A person’s emotional responses to risk taking can play a key role in their risk tolerance when investing.
The Takeaway
By knowing how to calculate return on equity, investors can have a comparative metric to turn to that can help them evaluate and compare different companies.
To use return on equity effectively, however, you’ll need to know where to find the relevant numbers and what to look out for. Also remember the ROE isn’t the only metric to consider — you’ll also want to take into consideration information found in financial documents, other financial ratios, your own risk tolerance, and more.
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