Return on Equity: How Well Does a Company Make Money?

Companies, like people, come in all shapes and sizes. Trying to understand if a certain amount of debt, net income, or assets is normal for a company be very difficult if you don’t know exactly how large the company is. When your childhood lemonade stand made 10$ in a day it was a pretty good day; If your small business were to do the same today it wouldn’t be as great (I’m assuming that most of our readers are over the age of 8). We need something to scale the size of the number we are looking at to the size of the company. This need to scale a company’s financials are why ratios are such a great tool for analyzing corporations. Today we are going to take a look at another ratio: Return on Equity (ROE).

What is ROE?

Return on Equity is a ratio which basically tells us how much money the company is able to generate off of its capital. It is calculated by dividing the net income (profits) by the shareholders’ equity. Unlike EPS, ROE is more than just a measure of profitability. Return on Equity gives us a look at the efficiency of the company. In other words, how many dollars of profit can a company make off of 1$ of capital.

Why Use ROE?

Many famous investors look at return on equity as an important part of their stock analysis process. Warren Buffett is known value return on equity as one of the most important factors when analyzing a company. A return on equity of over 40% is ideal. However, average ROE does differ by industry so while 40% is a good benchmark it is a good idea to take a look at the industry averages to get a better idea of how the company stacks up.  Also, look for a ROE that has been increasing, as this is a good indicator that the company is growing.

What to Look Out For

While ROE is a great metric to look at, there are a few things an investor should be aware of. Because ROE gets larger when shareholders’ equity declines, there are a few situations where a company’s ROE can be artificially high. For example, if a company carries a lot of debt, this can give them an artificially high ROE.  Because shareholders’ equity is assets minus liabilities by increasing liabilities shareholders’ equity decreases thus increasing the ROE ratio. Another thing that can increase return on equity without increasing the company’s efficiency is a share buyback. A share buyback is when a company buys its own shares back from the public. When a corporation buys back its shares it decreases its share capital. This in turn reduces shareholders’ equity and makes the companies ROE more attractive than it ought to be.

ROE is a great ratio because it lets us look at a companies’ efficiency instead of just its profitability. Also, because it is a ratio it is easy to compare different companies without worrying if one company is larger than the other. A good return on equity can be a really strong indicator of a good company. Make sure the ROE has not been pushed artificially high and it will be a fantastic metric to help you find great companies at bargain prices.

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