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Learning to Invest / Terms, Definitions, & Jargon
|Subject: Return on Equity (ROE)||Date: 3/24/1999 5:37 PM|
|Author: TMFSelena||Number: 6 of 2201|
Here's a piece in progress on ROE. If anyone can improve on, correct, or add to it, go for it.
Return on Equity (ROE)
Return on equity (ROE) is one of the best barometers of management excellence.
Whenever a company generates profits, there are four main things it can do with that moolah. It can pay shareholders a dividend, pay down debt, buy back shares of the company stock, or reinvest in operations. Return on equity reveals how effectively reinvested earnings and capital that shareholders originally invested in the company are used to generate additional earnings. For example, profits might be used to acquire another company. Or a new factory might be built, upping the firm's output and sales.
Technically, ROE is a measure of how much in earnings a company generates in four quarters compared to its average shareholder equity for the period. It's measured as a percentage. For instance, if XYZ Corp. made a million dollars in the past year and has shareholder's equity of ten million, then the ROE is 10%. In 1996, General Electric earned $7.3 billion and had shareholder equity of $31.1 billion. Divide 7.3 by 31.1 and you get an impressive ROE of 0.23, or 23 percent.
Some use ROE as a screen to find companies that can generate large profits with little in the way of capital investment. Coca-Cola, for instance, does not require constant spending to upgrade equipment -- the syrup-making process does not regularly move ahead by technological leaps and bounds. In fact, high ROE companies are so attractive to some investors that they will take the ROE and average it with the expected earnings growth in order to figure out a fair multiple. This is why a pharmaceutical company like Merck can grow at 10% or so every year but consistently trade at 20 times earnings or more.
ROE = trailing 12-month earnings / Ave. Shareholder Equity
0.23 = $31,100/ $7,300
0.23 = 23%
Look for: The higher the ROE, the better. Remember that ROEs vary by industry, so compare a company's ROE with those of its peers. It's also instructive to compare ROE for a single company over time. If you look at ROE over the past four or five years, is it rising or falling? (Rising is promising, of course.)
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