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ROE is the single best tool for
investors
Return on
Equity (“ROE”) is the rate of return that a company makes on its
shareholders’ equity. It is calculated by dividing annualized net income by
average shareholders equity and is stated as a percentage.
The nice feature of ROE is that one can compare the
returns from all sorts of investment alternatives. It levels the playing
field; it simply answers the question: “what rate of return is the company
making on its equity?”
The ROE ratio focuses on the effectiveness of
management in deploying its equity dollars. Many investors narrowly focus on
earning growth. Growth, while important, is not that difficult; by putting
your money in a CD, one can grow earnings. It’s the rate of return that’s
important. ROE, however, focuses on how effectively the earnings of a
company are being reinvested. Just by looking at ROE trends, one can
determine how management is doing.
Financial maneuvering, moreover, can improve results.
Distributing excess cash as dividends or repurchasing shares, for example,
reduces equity, and thus increases ROE going forward.
What is a good ROE percentage? Just compare rates.
Look at CD’s, Fannie Mae’s, corporate bond yields, real estate returns, etc.
Take the rates from a risk-free financial instrument, like US treasury
bonds, and add 5 to 7% more for the extra risk involved in running a
business. Historically, 15% was a nice return on equity. Companies like
Microsoft would return 25% to 30% plus per year. Now that they are a more
mature company, even their returns are declining to the 15% to 20% range
ROE is a
universal financial ratio applicable to all investment categories.
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