Return on Equity (ROE) in Stock Analysis
(includes calculator)
Return on Equity (ROE) is a measure of a corporation’s profitability that demonstrates the level of profit a company generates with the money invested by its shareholders. A high ROE means that surplus funds can be utilized to improve and expand the operations of the business without the shareholders having to invest more capital. A company with solid return on equity has less of a need to take on high levels of debt.
Calculating the ROE
Most analysts agree that return on equity is one of the most important profitability measures. The calculation is quite simple:
ROE = Net Profit After Taxes ÷ Stockholders’ Equity
An investor can easily gauge to what extent the company is an asset creator (as opposed to a consumer of cash) by looking at the measure. In relating earnings to shareholder equity, the level of cash that comes from existing assets can quickly be determined. In general, the higher a company’s return on equity compared to its industry, the better. Many analysts look for at least 15 percent when evaluating investment candidates.
A Measure of Management Efficiency
ROE is about the company’s management of pricing, assets, and financial leverage. Knowing this, the measure becomes not only one of financial return off of the equity it has created but also of the level of success the executive team has achieved in running the business. A rising ROE indicates that the company is increasing its ability to generate profit while requiring less capital.
ROE and Earnings Growth
It’s worth noting that, unless the company increases its profit margin , it cannot grow its earnings at a rate that exceeds its return on equity without raising additional cash (through borrowing or selling more shares). In other words, a firm with a 10 percent ROE cannot grow earnings faster than 10 percent annually. For this reason many investors look to the company’s return on equity to gauge its growth potential.
A Caution Regarding the Measure
It is important to note that if the value of the shareholders’ equity decreases, ROE increases. Share buybacks, for example, can artificially increase return on equity. A high level of debt can also artificially improve the measure as a higher level of debt means less shareholder equity and higher ROE.
Microsoft’s Return on Equity
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The above information is educational and should not be interpreted as financial advice. For advice that is specific to your circumstances, you should consult a financial or tax advisor.
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