More of this Feature • Introduction • Income Statement • Revenue / sales • Cost of Goods Sold • Gross profit • Gross margin • The first three lines • Operating Expenses • R&D Expense • SG&A Expense • Goodwill Charges • Extraordinary Events • Accounting for extraordinary events • Oper. income/margin • Interest income and expense • Interest coverage ratio • Depreciation expense • Accum. Depreciation • Straight-line Method • Accelerated and Sum of the Years' Digits Method • Dbl Declining Balance • Comparing Depr. Mths • EBITDA • Income taxes • Minority Interests - cost, equity, and consolidated methods • Unreported earnings • Continuing operations • Accounting changes • Preferred dividends • Net income applicable to common shares • Net profit margin • Basic vs. Diluted EPS • Hiding share dilution • Share repurchases • Return on Equity- ROE • Asset turnover • Return on Assets- ROA • Projecting earnings • Formulas & Calculations • Putting it together • Segment 2

Related Resources • Investing Lesson 1 • Investing Lesson 2 • Investing Lesson 3 • More Lessons

From Other Guides • Johnson Controls - Return on Equity Example • Fundamental Analysis, Including Return on Equity, from your About.com Stocks Guide

Elsewhere on the Web • Return on Equity, ROE - The Motley Fool • Return on Equity vs. Return on Capital • Return on Equity - earnings and income • Return on Equity - ROE, from Investopedia • What's Driving Return on Equity

Return on Equity – ROE
One of the most important profitability metrics is return on equity [or ROE for short]. Return on equity reveals how much profit a company earned in comparison to the total amount of shareholder equity found on the balance sheet. If you think back to lesson three, you will remember that shareholder equity is equal to total assets minus total liabilities. It’s what the shareholders “own”. Shareholder equity is a creation of accounting that represents the assets created by the retained earnings of the business and the paid-in capital of the owners.

A business that has a high return on equity is more likely to be one that is capable of generating cash internally. For the most part, the higher a company’s return on equity compared to its industry, the better. This should be obvious to even the less-than-astute investor If you owned a business that had a net worth [shareholder’s equity] of $100 million dollars and it made $5 million in profit, it would be earning 5% on your equity [$5 / $100 = .05, or 5%]. The higher you can get the “return” on your equity, in this case 5%, the better.

Formula for Return on Equity
The formula for Return on Equity is:

Net Profit
----------(divided by)----------
Average Shareholder Equity for Period

Return on Equity Example
 

Now that we have the income statement and balance sheet in front of us, our only job is to plug a the numbers into our equation. The earnings for 2001 were $21,906,000 [because the amounts are in thousands, take the figure shown, in this case $21,906, and multiply by 1,000. Almost all publicly traded companies short-hand their financial statements in thousands or millions to save space]. The average shareholder equity for the period is $209,154,000 [$222,192,000 + 196,116,000 divided by 2].

Let’s plug the numbers into the formula.

$21,906,000 earnings
-------------(divided by) -------------
$209,154,000 average shareholder equity for period

The answer is 0.1047, or 10.47%. This 10.47% is the return that management is earning on shareholder equity. Is this good? For most of the twentieth century, the S&P 500 [a measure of the biggest and best public companies in America] averaged ROE's of 10 to 15%. In the 1990’s, the average return on equity was in excess of 20%. Obviously, these twenty-plus percent figures probably won’t endure forever. In the past two years alone, small and large corporations alike have issued repeated earnings revisions, warning investors they will not meet analysts’ quarterly and / or annual estimates.

Return on equity is particularly important because it can help you cut through the garbage spieled out by most CEO’s in their annual reports about, “achieving record earnings”. Warren Buffett pointed out years ago that achieving higher earnings each year is an easy task. Why? Each year, a successful company generates profits. If management did nothing more than retain those earnings and stick them a simple passbook savings account yielding 4% annually, they would be able to report “record earnings” because of the interest they earned. Were the shareholders better off? Not at all; they would have enjoyed heftier returns had the earnings been paid out. This makes obvious that investors cannot look at rising per-share earnings each year as a sign of success. The return on equity figure takes into account the retained earnings from previous years, and tells investors how effectively their capital is being reinvested. Thus, it serves as a far better gauge of management’s fiscal adeptness than the annual earnings per share.

The return on equity calculation can be as detailed as you desire. Most financial sites and resources calculate return on common equity by taking the income available to the common stock holders for the trailing [most recent] twelve months and dividing it by the average shareholder equity for the most recent five quarters. Some analysts will actually “annualize” the recent quarter by simply taking the current income and multiplying it by four. The theory is that this will equal the annual income of the business. In many cases, this can lead to disastrous and grossly incorrect results. Take a retail store such as Lord & Taylor or American Eagle, for example. In some cases, fifty-percent or more of the store’s income and revenue is generated in the fourth quarter during the traditional Christmas shopping period. An investor should be exceedingly cautious not to annualize the earnings for seasonal businesses.

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