Return on equity, or ROE, can be a useful measure of evaluating a company's profitability relative to other businesses. Basically, it tells us how efficiently a company is using its shareholders' equity to produce profits.
Here's a quick overview of how ROE is calculated, what it means, and how you can use it when making investment decisions.
The basic formula
Return on equity can be determined by taking a company's net income and dividing it by shareholders' equity. Higher-growth companies generally have higher ROEs, and this metric is most useful for comparing a business with its peer group. In other words, comparing the ROE of a bank to the ROE of a tech stock wouldn't be very useful.
What is shareholders' equity?
Shareholders' equity refers to a company's total assets minus its liabilities, and this can be very different from a company's share price. In other words, shareholders' equity is how much money would be left (theoretically) if a company sold off all of its assets and paid all of its debts.
For example, as of the most recent quarter, Apple (NASDAQ:AAPL) had assets totaling nearly $232 billion and liabilities totaling about $120 billion, so its shareholders' equity was roughly $112 billion. Based on Apple's net income over the past 12 months, the company's ROE is about 33.6%, well above the tech sector's average of 28.8%.
Shareholders' equity can be negative if a company's debts are higher than its assets. This is fairly common among newer companies, but is possible for a business in any stage. For instance, as of the most recent quarter, AutoZone (NYSE:AZO) had assets totaling about $7.7 billion and liabilities totaling $9.4 billion. However, since AutoZone is growing earnings at an impressive rate, negative equity isn't necessarily a major problem.
These three banks have trailing-12-month ROEs of 2.2%, 13.4%, and 13.8%, respectively, as of this writing. So, at first glance, it's fair to say that U.S. Bancorp is the most efficient at generating profits from its shareholders' equity. This makes sense considering that US Bancorp trades at a premium valuation to the other two, followed by Wells Fargo.
However, it's important to note that ROE, or any single metric for that matter, never tells the whole story. For example, Bank of America's ROE looks deceptively low because of recent massive (but one-time) legal expenses.
Watch out for debt
As in the AutoZone example, return on equity is tied closely to a company's debt, so watch for an ROE that is high simply because the company has a lot of debt. For this reason, many investors prefer to look instead at ROIC (return on invested capital), which can offer a much better idea of the actual return you can expect on your investment.
However, ROE can be an effective way to evaluate a company's profitability, as long as it is used in conjunction with a thorough analysis of the business, including its debt.
Matthew Frankel owns shares of Bank of America. The Motley Fool recommends Apple and Bank of America. The Motley Fool owns shares of Apple and Bank of America. 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.