Since investing is about putting your money to work, it is important to know how you’re money will be used and whether it will be used effectively. Return on Equity gives you a good indication of how well a company will use your investment money to generate profit.
The common sense investor needs to be armed with concepts that help to measure the quality of an investment. One of the most important concepts in the investing business is “return on equity” – (ROE). ROE gives you one of the best and most precise insights into how well a company will use your money. The ROE of a stock reveals how much profit a company has earned in comparison to the total amount of shareholder equity found on the balance sheet.
Shareholder equity is defined as the total assets minus total liabilities. The equity is what the shareholders own. Shareholder equity basically represents the assets that have been created by a business’ retained earnings and the owners’ paid-in capital.
In theory, a business that shows a high return on equity is likely to be more capable of generating cash internally. The general rule of thumb is, the higher a company’s return on equity is compared to its industry, the better.
Return on equity is particularly useful for the common sense investor because it can help him cut through the PR drivel and fluffed up corporate statements that are churned out by most CEOs in their respective annual reports. So when they attempt to paint a pretty picture by saying that Company A has “achieved record earnings” you can get a much more complete picture of the companies health by doing a quick computation of the return on equity. This will help you discern whether a company is actually putting its equity to good use for its shareholders.
Warren Buffett, one of the most successful investors in the world, used to say that getting higher earnings each year is an easy task. He is just pointing out the obvious. Companies who are successful generate profits. If the company management would simply institute a policy of retaining the earnings and putting it into a simple passbook savings account that earns annual interests, they already have the ingredients that will enable them to report record earnings simply for the interest they will get from the earnings. The question though is, are shareholders better off with this approach? Would the company be using your money well?
Not at all.
Shareholders would have earned more substantial returns if the earnings were paid out or reinvested for the sake of growth and production. This makes it apparent that investors must not look at rising annual per-share earnings as a sign of a company’s success. A return on equity figure, on the other hand, takes into account the retained earnings from previous years. This indicates to effectively their capital is being reinvested. Thus, it ultimately becomes a far better barometer of management’s proficiency in handling the fiscal responsibilities compared to the more commonly used annual earnings per share.
Calculating return on equity can be as detailed as you like. Most financial sites calculate return on common equity by taking the income made available to stockholders for the most recent twelve months and dividing it by the average shareholder equity for the most recent five quarters.