It's easy to get carried away when you start investing. Upon learning to calculate my first few ratios, I began making spreadsheets and comparing companies based on very few measures, drawing rather uninformed conclusions. A handful of measures alone, however appealing they may seem, can often disguise deeper problems with a stock. In the rogues' gallery of such metrics, return on equity (ROE) stands out as a particularly tricky customer.
ROE shows you how much in net income a company is making per dollar of shareholder equity. To calculate it, take net income for a period (such as a year) and divide it by average shareholder equity over the same period. The higher the number, the better -- generally.
For instance, check out these companies with high returns on equity:
|
Company
|
Recent return on equity
|
|
Diageo (NYSE: DEO )
|
48%
|
|
Heinz (NYSE: HNZ )
|
52%
|
|
Kellogg (NYSE: K )
|
52%
|
|
Hershey
|
65%
|
|
Western Union (NYSE: WU )
|
728%
|
|
Yum! Brands (NYSE: YUM )
|
167%
|
|
Altria (NYSE: MO )
|
80%
|
Data: Capital IQ, a division of Standard and Poor's. ROE is for trailing 12 months.
They sure look high, don't they? And they are. Respected, high-performing Amazon.com (Nasdaq: AMZN ) has an ROE of just 24%.
A naive investor might get overly excited at this list of companies, without truly understanding how ROE is calculated. You see, high debt can inflate an ROE figure. You calculate shareholder equity it by subtracting liabilities from assets. If your liabilities (such as debt) are high, your shareholder equity will be low, thus making ROE steeper than it would have been with lower debt. Here -- check out the long-term debt-to-equity ratios for the companies above (in general, the lower the better, and numbers well below 1.0 are preferred):
|
Company
|
Long-term debt-to-equity
|
|
Diageo
|
2.39
|
|
Heinz
|
2.51
|
|
Kellogg
|
2.38
|
|
Hershey
|
2.52
|
|
Western Union
|
9.32
|
|
Yum! Brands
|
3.61
|
|
Altria
|
3.01
|
Data: Capital IQ, a division of Standard and Poor's.
See? High debt. Yum! Brands recently sported $434 million in cash and cash equivalents, and around $3.3 billion in debt. That much debt can sink some companies, if they're not able to service it. Yum! doesn't look that shaky, but still, you'll want to know its debt load before its 80% return on equity lures you into buying shares.
Be thorough when you study companies. The more you look at, the better an idea you'll have of whether a stock truly is a great investment.
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