When it comes to evaluating a business, especially one that is publicly traded, determining its return on equity (ROE) is one way to see how it’s performing.
What is Return on Equity?
Return on equity is a ratio that gives investors insight into how effectively a company’s management team is taking care of the shareholders’ financial investments in the company. The greater the ROE percentage, the better the business’ management staff is at making income and creating growth from shareholders’ investments.
How ROE is Determined
In order to calculate ROE, a company’s net income is divided by shareholder equity. To arrive at net income, businesses account for the cost of doing business, which includes the cost of goods sold, sales, operating and general expenses, interest, tax payments, etc. and then subtracts these costs of doing business from all sales. Similarly, the free cash flow figure can be substituted in place of net income.
There are some caveats when it comes to calculating net income. It is determined prior to paying out dividends to common shareholders, but loan interest and preferred shareholder dividend obligations must be met before starting this calculation.
The other part of the equation is the shareholder equity or stockholders’ equity. One way to determine this is to subtract existing liabilities from a business’ assets. The remainder is what owners of a corporation, or its shareholders, would be able to claim as their equity in the company. Whether the calculations is done year over year or quarter over quarter, traders and investors can see how well a company performs over different time periods.
Return on equity can also help determine if a business’ net income and equity are in the black. The net income is found on the income statement – the ledger of the company’s financial transactions. Shareholders’ equity is found on the balance sheet – which details the business’ assets and financial obligations.
Analyzing a Business’ ROE
Another consideration that industry experts recommend to determine if a company’s ROE is poor or excellent is to see how it compares to the S&P 500 Index’s performance. With the historical rate of return being 10 percent annually over the past decade, if a ROE is lower than 10 percent, it can give a good indication as to a particular business’ performance. However, a particular company’s ROE also needs to be compared against the industry’s ROE to see if the company is outperforming its sector.
For example, according to Yahoo Finance!, the ROE on Microsoft’s stock is 42.80 percent. This means that the management team running Microsoft is returning just shy of 43 cents for every dollar in shareholders’ equity. Compared to its industry (Software System & Application) ROE of 13.47 percent – as cited by New York University’s Stern School of Business – Microsoft has a much higher ROE compared to the industry average. This is just one metric to measure the company’s performance, but it is an important one.
While looking at a company’s return on equity is not the end all or be all, it’s a good start to determine a company’s present and future financial health.