A Return on Equity Approach for Independent Investors
- Return on equity divides annual earnings by shareholder equity. Annual earnings are the money that a company brought in in one year. Shareholder equity is the difference between assets and liabilities on the balance sheet -- the amount of value that a company has that is owned by shareholders. By dividing earnings by equity, ROE (expressed as a percentage) tells investors how much money they get back each year for every dollar they have invested.
- ROE essentially assesses how well a company uses the money its shareholders give it and what the shareholders can expect back from the company. For example, if an investor puts $10,000 into a company with a ROE of 15 percent, she can expect her equity -- her share of value in the company -- to grow by 15 percent every year. Even better, ROE allows a shareholder to compare how well companies from different industries use investment money.
- The Motley Fool points out that a seemingly simple metric actually involves a number of important cogs in the company, because three main areas affect ROE. ROE assesses profitability through factoring in earnings and asset management -- how efficiently the company manages its assets to maximize profit and minimize inventory costs. ROE also assesses how well a company uses leverage -- the amount of debt it can take on.
- Investors increasingly turn to return on invested capital (ROIC) as well as ROE. Companies can temporarily and artificially increase ROE by taking on debt. Debt means an influx of capital into the company from a non-shareholder source, which allows the company to produce more using the same shareholder equity numbers, therefore boosting ROE. However, after a point, the debt starts to cost more than the extra production brings in, interest rates drag down net profits and having a lot of debt on the balance sheet is risky.
ROIC looks at the return of all capital in the business, meaning that the ROIC percentage measures the return in earnings for each dollar the company puts into the business, including debt. With ROIC, more debt dilutes the returns on each dollar unless the company uses its debt to boost performance above the debt's interest rate.
