Trillionaire Term of the Day - January 12, 2009

Return on Equity (ROE)

Return on Equity is a widely used financial indicator that is usually expressed as a percentage. It can be found by dividing Net income by Shareholder’s Equity:

                                                            Net Income

                                                -------------------------------

                                                    Shareholder’s Equity

The net income used for this equation is calculated before declaring common stock dividends. Shareholder’s Equity can be found by simply taking Total Assets – Total Liabilities.

Return on Equity is used to determine how effectively a company uses their equity to create income. On a basic level, the higher percentage ROE is, the more effective the company is at creating profit.

ROE can be a great tool for comparing two companies that are in the same sector. All other factors aside, if company A has an ROE of 10% and company B has an ROE of 20%, then company B appears to be the more profitable company.

Let’s take a real world example with a previous “stock of the day”, Yahoo! (YHOO).  Yahoo has a return on equity of  8.94%. Its biggest competitor, Google (GOOG), has a ROE of 20.82%. Using these numbers, it’s pretty easy to see that Google generates income more effectively than Yahoo!.

It is important for you to note here that I used two stocks that are in the same sector. Return on Equity statistics are almost worthless if you’re comparing two companies that do completely different things. Tech stocks like Google and Yahoo! have much lower capital requirements than, say, an auto manufacture like GM or Ford. The lower capital requirements for tech stocks create higher Return on Equity. So, make sure you are comparing companies in the same sector when using ROE to conduct research!

When properly handled, ROE can be a powerful tool in your arsenal for investing.

 

-Matt Schwartz

College Trillionaire