Return on equity, often abbreviated as ROE, is a financial metric used to judge the strength of a business by answering this key question: How much profit does it generate as a function of the cash it has to work with? In other words, one dollar of equity translates into exactly how many dollars of earnings?
The best businesses and the most skilled management teams will typically produce a consistently high rate of return on common stock equity.
To calculate ROE you only need two figures, both of which are available in a company's 10-K annual report. First, grab net income from the income statement (sometimes it's called "net earnings" and found in the "earnings statement"). Next, pull shareholders' (or "stockholders'") equity from the balance sheet. Divide the first figure by the second, and voila, you've figured out the return on stock equity.
Here's an example calculation using home improvement giant, Home Depot's (NYSE: HD) fiscal 2014 results. That year, the retailer booked a total of $6.3 billion of profit, or net earnings:
Home Depot also had $9.3 billion of stock equity on its books as of the end of 2014:
Dividing $6.3 billion (income) by $9.3 billion (equity) yields a rate of return on equity of 68%. That percentage means that Home Depot generated $0.68 of profit for every $1 that management had available to work with in 2014.
Why ROE matters
Consistently high rates of return on equity are unusual in the business world. In fact, Home Depot's 68% figure puts it in the top 3% of the 500 companies that make up the S&P 500 index.
That's why ROE is one number that legendary investor and Berkshire Hathaway CEO Warren Buffett often discusses when he is talking about strong businesses. In his 1987 letter to shareholders, for example, Buffett noted that Berkshire's largest divisions as a group earned a 57% ROE that year, which was higher than any of the 1,000 largest publicly traded companies. "You'll seldom see such a percentage anywhere, let alone at large, diversified companies" with no debt, he said.
Yet it's important to remember that an investor's return, judged in terms of their share of generated earnings, will almost always be much lower than a company's ROE. That's due to the fact that shares are typically purchased at a substantial premium to the carrying value of equity on a company's books. Home Depot's market capitalization is close to $150 billion, or about 16 times its shareholders' equity figure.
Still, calculating a company's ROE -- particularly in comparison to rivals within the same industry -- is a great way to find out whether the stock you're evaluating is being effectively managed and has a strong underlying business.
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Demitrios Kalogeropoulos owns shares of Home Depot, as does the Motley Fool. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.