Disarmingly simple to calculate, return on equity is a critical weapon in the investor's arsenal, as long as it's properly understood for what it is. ROE encompasses the three pillars of corporate management -- profitability, asset management, and financial leverage. By seeing how well the executive team balances these components, investors can not only get an excellent sense of whether they will receive a decent return on equity but can 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 equity for that year. The earnings number can come directly from the Consolidated Statement of Earnings in the company's most recent annual filing with the SEC. It can also be figured as the sum of the past four quarters' worth of earnings, or as the average of the past five or 10 years' earnings, or it can even be an annualized figure based on the previous quarter's results. However, investors should be careful not to annualize the results of a seasonal business, in which all of the profit is booked in one or two quarters.

The shareholder-equity number is located on the balance sheet. Simply the difference between total assets and total liabilities, shareholder equity is an accounting convention that represents the assets that the business has generated. It's assumed that assets without corresponding liabilities are the direct creation of the shareholder capital that got the business started in the first place.

The usual way investors will see shareholder equity displayed is as "book value" -- the amount of shareholder equity per share, or the accounting book value of the business beyond its market value or intrinsic economic value. A business that creates a lot of shareholder equity is a sound investment, because the original investors will be repaid with the proceeds that come from the business operations. Businesses that generate high returns relative to their shareholder equity pay their shareholders handsomely and create substantial assets for every dollar invested. These businesses are typically self-funding and require no additional debt or equity investments.

To quickly gauge whether a company is an asset creator or a cash consumer, look at the ROE it generates. By relating the earnings to the shareholder equity, an investor can quickly see how much cash comes from existing assets. If the ROE is 20%, for instance, then 20 cents of assets are created for every dollar originally invested. As additional cash investments increase on the asset side of the balance sheet, the ROE number shows whether additional dollars invested are dollars of return from previous investments.

If return on equity is simply:

ROE = one year's earnings / shareholder 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, we can start to take into account other variables. (We apologize if this gives you a flashback to high school algebra.)

ROE = (one year's earnings / one year's sales) x (one year's sales / assets) x (assets / shareholder equity)    

Because the sales and the assets are both in the numerator and the denominator of the entire equation, they cancel one another out. When we break the equation apart in this manner, the three component parts of ROE 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. We'll discuss each one, and after we complete our analysis, we'll come back to ROE and how this composite number can be used to evaluate companies. We'll also explore its limitations as an analytical tool.

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