Introduction
The Return on Equity (ROE) is one of the metrics that helps assess a company’s efficiency in using its assets to generate profits, and understanding this value can help you evaluate stocks.
How to Calculate Return on Equity
You can calculate Return on Equity by dividing net income by book value. A healthy company may produce a return on equity in the range of 13-15%, and like all metrics, comparing companies within the same industry will give you a better picture.
Some Potential Drawbacks
While Return on Equity is a useful metric, it comes with some drawbacks that can give you a misleading picture. You should not rely solely on Return on Equity.
For instance, a company may carry significant debt and raise money through borrowing instead of issuing stock, which will reduce the book value. A lower book value means you’re dividing by a smaller number, and the return on equity will be artificially higher. Other situations can also reduce book value, such as taking losses, buying back shares, or any other accounting gimmick. All these factors will produce a higher return on equity without improving profits.
Looking at Return on Equity over the past five years instead of just one year will help you average out any abnormal numbers. Considering the overall picture, Return on Equity is a useful tool when it comes to identifying companies with a competitive advantage. When everything else is nearly equal, the company that can consistently extract more profits from its assets will be a better long-term investment.
Other Terms to Understand
Take some time to read and explore the following concepts for optimal success:
– Earnings per Share (EPS): This is the company’s net income divided by the number of outstanding common shares.
– Price to Earnings Ratio (P/E Ratio): This measures the company’s current share price relative to its earnings per share.
– Expected Earnings Growth (PEG): This weighs the share price against the earnings generated per share and the company’s expected growth.
– Price to Sales Ratio (P/S): This ratio is a measure used to evaluate stocks. You divide the company’s market value by its total annual sales for the most recent full year. You can also reach the price to sales ratio by dividing the share price by the company’s sales per share.
– Price to Book Ratio (P/B): Also called the price to earnings ratio. It compares a share’s book value to its market value. You can find it by dividing the current closing price by the book value per share from the last quarter.
– Dividend Payout Ratio: This is the amount of earnings that stockholders receive compared to the company’s total net income.
– Dividend Yield: This is found by dividing the dividend per share by the stock price.
– Book Value: This is the total value of a company’s assets, minus liabilities. It does not include intangible assets like patents.
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Source: https://www.thebalancemoney.com/understanding-return-on-equity-3140790
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