Understanding Return on Equity

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 billions of dollars 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 13–15% range, and 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, it raises funds through borrowing rather than issuing stock, and this will reduce its book value. A lower book value means that you're dividing by a smaller number, and the ROE will be artificially higher. Other situations can also reduce book value, such as taking write-downs, stock buybacks, or any other accounting sleight of hand. All of these things will produce a higher ROE without actually improving profits.

Looking at the ROE over the past five years rather than just one year 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 its 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): A company's profit divided by the amount of outstanding common shares.
• Price-to-Earnings Ratio (P/E Ratio): 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 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):Sometimes called the price-to-equity ratio, the P/B ratio compares a stock's book value to its market value. You can find it by dividing the current closing price by the last quarter's book value per share. 
• Dividend Payout Ratio: The amount of dividends stockholders receive compared to the company's total net income.
• Dividend Yield: Found by dividing the dividend per share by the share price.
• Book Value : The total asset value of the company less liabilities. It does not include intangible assets such as patents.