Return on Equity: A Definition

Disarmingly simple to calculate, return on equity (ROE) stands as a critical weapon in the investor's arsenal if properly understood for what it is. Return on equity encompasses the three main "levers" by which management can poke and prod the corporation -- profitability, asset management, and financial leverage. By perceiving return on equity as a composite that represents the executive team's ability to balance these three pillars of corporate management, investors can not only get an excellent sense of whether they will receive a decent return on equity but also assess management's ability to get the job done.

Return on equity is calculated by taking a year's worth of earnings and dividing them by the average shareholder's equity for that year. The earnings can be taken directly from the Consolidated Statement of Earnings in the company's last annual filing with the Securities Exchange Commission (SEC), or they can be taken as the sum of the last four quarters worth of earnings. They can also be figured using the average of the last five or ten year's earnings, or they can simply be annualized based on the last quarter's results. (Investors should be careful not to annualize the results of a seasonal business where all of the profit is booked in one or two quarters.)

Shareholder's equity can be found on the balance sheet and is simply the difference between the total assets and total liabilities, as it is assumed that assets without corresponding liabilities are the direct creation of the shareholder's capital that got the business started in the first place. Shareholder's equity is an accounting convention that represents the assets that have actually been generated by the business.

The most common way that investors see shareholder's equity displayed is as a per share value called "book value." Book value is the amount of shareholder's equity per share, or the accounting book value of the business outside of its market value or intrinsic economic value. A business that creates a lot of shareholder equity is a business that is a sound investment, as the original investors in the business will be able to be repaid with the proceeds that come from the business operations. Businesses that generate high returns relative to their shareholder's equity are businesses that pay their shareholders off handsomely, creating substantial assets for each dollar invested. These businesses are more than likely self-funding companies that require no additional debt or equity investments.

One of the quickest ways to gauge whether a company is an asset creator or a cash consumer is to look at the return on equity that it generates. By relating the earnings generated to the shareholder's equity, an investor can quickly see how much cash is created from the existing assets. If the return on equity is 20%, for instance, then twenty cents of assets are created for each dollar that was originally invested. As additional cash investments increase the asset side of the balance sheet, this number ensures that additional dollars invested to not appear to be dollars of return from previous investments.

If return on equity is simply:

   One year's earnings
ROE = -------------------------
  Shareholder's Equity

...then how is it that we can see the profit margin, asset management, and financial leverage through this one calculation? If we expand the equation, unfortunately giving many readers algebra flashbacks, we can start to take into account other variables.

     
ROE = 
  One year's earnings
----------------------- *
   One year's sales

   One year's sales
----------------------- *
 Assets

 Assets
-----------------------
 Shareholder's Equity

Because the sales and the assets are both in the numerator and the denominator of the entire equation, they cancel one another out. (For those too stunned by the algebra to fully comprehend the above, you'll have to trust me.) When we break the equation apart in this manner, the three component parts of return on equity come to light. Earnings over sales is profit margin, sales over assets is asset turnover, and assets over equity is the amount of leverage the company has. Each will be discussed on its own merits. After we have completed this analysis, we will come back to return on equity and how this composite number can be used to evaluate a particular company, as well as exploring its limitations as an analytical tool.