Understanding Return on Equity

Understanding return on equity can help you size up stocks

Businessmen with stock index
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You can give some management teams a couple of boards, some glue, and a ball of string, and they'll build a profitable, growing business. Other teams can't come close, even when they have several billion dollars' worth of assets at their disposal. Return on equity (ROE) is one measure of how efficiently a company uses its assets to produce earnings, and understanding this value can help you evaluate stocks.

How to Calculate ROE

You can calculate ROE by dividing net income by book value. A healthy company might produce an ROE in the 13 to 15 percent range. As with all metrics, comparing companies within the same industry will give you a better picture.

Some Potential Flaws 

Although ROE is a useful measure, it does come with some flaws that can give you a false picture. You should never rely on ROE alone.

For example, a company might carry a large debt so it raises funds through borrowing rather than issuing stock. This will reduce its book value. A lower book value means that you're dividing by a smaller number so the ROE will be artificially higher. Other situations can also reduce book value, such as taking write-downs, stock buy-backs, or any other accounting sleight of hand. All of these things will produce a higher ROE without actually improving profits.

It might also be more meaningful to look at the ROE over a period of the past five years rather than just one year. This will help you average out any abnormal numbers.

Given that you must look at the total picture, ROE is a useful tool when it comes to identifying companies with a competitive advantage. When all other things are pretty much equal, a company that can consistently squeeze out more profits with their assets will be a better investment in the long run.

Other Terms to Understand 

Take some time and do some further reading to understand the following concepts as well for optimal success. 

  • Earnings per Share (EPS): What portion of the company's profits are dedicated to a share of its common stock?
  • Price to Earnings Ratio (PE): This measures a company's current share price against its per-share earnings. 
  • Projected Earning Growth (PEG): This metric weighs the price of a stock relative to earnings generated per share and the anticipated growth of the company. 
  • Price to Sales (P/S): This ratio also serves as a metric to value stocks. Divide the company's market cap by its yearly revenue for the most recent full year. You can also arrive at price to sales by dividing a stock's price per share by the company's per-share revenue. 
  • Price to Book (P/B): Also sometimes called the price to equity ratio, the P/B ratio compares a stock's book value to its market value. Divide the current closing price by last quarter's book value per share. 
  • Dividend Payout Ratio: How much in the way of dividends do stockholders receive compared to the total net income of the company?
  • Dividend Yield: This is a percentage of a current share price. Learn how to calculate it. 
  • Book Value : This is the total asset value of the company less liabilities. It does not include intangible assets such as patents.