ROE measures how much profit a company generates per dollar of shareholders’ equity.
Return on equity (ROE) is a must-know financial ratio. It is one of many numbers investors can use to measure return and support investing decision. It measures how many dollars of profit are generated by a company’s management for each dollar of shareholder’s equity.
The metric reveals just how well the company utilizes its equity to generate profits. It reveals the company’s efficiency at turning shareholder investments into profits and explains, mathematically, the ratio of a company’s net income relative to its shareholder equity.
ROE is very useful for comparing the performance of similar companies in the same industry and can show you which are making most efficient use of their (and by extension investors’) money.
Billionaire investor Warren Buffett uses ROE as part of his investment decision making process. Buffet cares deeply about a company that uses its money wisely and efficiently. He believes that a successful stock investment is a result first and foremost of the underlying business; its value to the owner comes primarily from its ability to generate earnings at an increasing rate each year.
Buffett examines management’s use of owner’s equity, looking for management that has proven it is able to employ equity in new moneymaking ventures, or for stock buybacks when they offer a greater return.
What is ROE
Return on equity is a ratio of a public company’s net income to its shareholders’ equity, or the value of the company’s assets minus its liabilities. This is known as shareholders’ equity because it is the amount that would be divided up among those who held its stock if a company closed.
The basic formula for calculating ROE simply is to divide net income from a given period by shareholder equity. The net earnings can be found on the earnings statement from the company’s most recent annual report, and the shareholder equity will be listed on the company’s balance sheet. The specific ROE formula looks like this:
ROE = (Net Earnings / Shareholders’ Equity) x 100 or EPS / Book Value
“ROE tells you how good or bad management is doing with your investment,” says Mike Bailey, director of research at FBB Capital Partners in Bethesda, Maryland. “Higher ROEs generally stem from profitable businesses that enjoy competitive advantages within a given industry.”
A high ROE doesn’t always mean management is efficiently generating profits. ROE can be affected by the amount that a company borrows.
Increasing debt can cause ROE to grow even when management is not necessarily getting better at generating profit. Share buybacks and asset write-downs may also cause ROE to rise when the company’s profit is declining.
On the other hand, idle cash in excess of what the business needs to continue operations reduces the apparent profitability of the company when measured by return on equity. Distributing idle cash to shareholders is an effective way to boost its return on equity.
What is return on equity? pic.twitter.com/VzdRNWUKlp
— TheStreet (@TheStreet) December 19, 2019
Key Takeaway
Return on Equity measures how efficiently a company generates net income based on each dollar invested by company’s shareholders.
A steady or increasing ROE is a company that knows how to successfully reinvest their earnings. This is important because most companies retain their earnings in the equity of the business.
A declining ROE is symbolic of executive management that is unable to successfully reinvest their capital in income producing assets. Companies like this should elect to pay most of their earnings to shareholders as dividends.
References:
- https://smartasset.com/investing/return-on-equity
- https://www.forbes.com/advisor/investing/roe-return-on-equity/
- https://www.nasdaq.com/articles/5-ways-improve-return-equity-2015-01-21
- https://money.usnews.com/investing/articles/what-is-return-on-equity-the-ultimate-guide-to-roe