Education: Growth & Income Investing

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How to Determine Return on Equity

What is the most tangible proof that a company is worth holding for the long-term? If you answered earnings, take a bow.

Earning a profit is the goal of every company—or at least it should be (with not-for-profit organizations being an obvious exception). As a shareholder, or potential shareholder of a company, it should be in your best interest to know how much profit that company is generating with the money shareholders have invested in it. Return on equity (ROE) is a measure that can help investors in their search for lean, mean profit machines.

Return on Equity Defined

One of the key profitability metrics is return on equity. Return on equity measures how much profit a company is able to generate given the resources provided by its shareholders. ROE is calculated as follows:

ROE = Net Income/Shareholder’s Equity

Net income is a fancier way of saying profits, earnings or the bottom line. Shareholder’s equity is equal to a company's total assets minus its total liabilities. Or, simply put, the amount of assets that are owned by a company's shareholders. Net income can be found on a company’s income statement, while shareholder’s equity can be located on its balance sheet.

Calculation Example

Let's calculate ROE for the software giant Microsoft Corporation for its 2005 fiscal year which ended June 30, 2005. To get the necessary data, go to the www.zacks.com and enter Microsoft’s ticker (MSFT) into the cell in the upper left hand corner and hit the Go button. Under Quotes and Research, click on Financials and then Income Statement. Scroll down to the bottom where you will find Microsoft’s net income for fiscal 2005—$12.25 billion.

Now click on the Balance Sheet link (next to the Income Statement link). Scroll down towards the bottom of the statement and locate the figure next to Total Shareholder's Equity—$48.12 billion.

Now take the $12.25 billion in net income and divide that figure by the $48.12 billion in total shareholder’s equity. You will arrive at a return on equity of 0.25, or 25%. This figure informs investors that in the fiscal year 2005, Microsoft generated a 25% profit on every dollar invested by shareholders. Not bad, hub? Well…

Reading between the Lines

For ROE, the higher the better (can I get this logic to apply to my golf score as well?). Also, it helps if a company’s ROE has been on the rise. If so, management is finding better ways to use its shareholders’ money. However, please keep in mind that what makes for a good ROE is highly dependent on the industry in which the company participates.

Getting back to our Microsoft example. We calculated a ROE of 25% for the company. At face value this looks extremely attractive. But what if the ROE of the software industry currently stands at 35%? This would tell you that Microsoft’s profitability, as measured by its ROE, is less than the average of its peers/competitors. What are they doing differently, and why are they able to generate profits more efficiently than Microsoft?

To complicate things further, many investors fail to realize that two companies can have the same return on equity, yet one can be a much better business. We will provide some guidance on these issues towards the end of the article.

Not Entirely Flawless

Just like you and I, ROE has its flaws as well. Recall that ROE is calculated by taking net income and dividing that by shareholder’s equity. And that shareholder’s equity is assets less liabilities. Debt is not accounted for. Suppose that two firms have similar net incomes and assets. If so, the firm with the highest liabilities has the lowest shareholder’s equity, which will lead to a higher ROE.

Thus, you should take debt levels also into consideration when comparing the ROEs of different companies.

Another problem with return on equity has to do with share buybacks. Buybacks reduce the assets on a company’s balance sheet—there is an outflow of cash. As a result, ROE increases because shareholder’s equity is lower.

Earnings Estimate Revisions and the Zacks Rank

No metric on its own is sufficient enough to single out stocks worth purchasing. This applies to ROE as well as the many other metrics and ratios at investors’ fingertips. While ROE can serve as a key measure of management effectiveness, when used in conjunction with positive earnings estimate revisions and the Zacks Rank, you can narrow your search down to companies that are truly delivering shareholder value.

ROE is a handy tool that growth and income investors can use to identify profitable industry leaders. However, while a firm may have been profitable in the past by no means guarantees it will continue to give shareholders more for their money. Stock prices can be quite volatile in the short term. It is recommended that ROE be combined with other fundamental yardsticks—namely earnings estimate revisions.

Earnings estimate revisions have a tremendous impact on stock prices and serve as the single best gauge of the future prospects of a company. And the best way to harness this phenomenon is through the Zacks Rank. (Learn more about the Zacks Rank).

Furthermore, to help in your search, Zacks offers a Profit Track strategy that uses ROE, in addition to other parameters, to discover solid stocks. We provide all the parameters used in this strategy as well as detailed performance information. Run this Profit Track Now.