What Is Return on Equity: The Ultimate Guide to ROE

Return on equity, or ROE, is a measure of how efficiently a company is using shareholders’ money. Since efficient companies tend to be more profitable companies, and more profitable companies tend to make better investments, investors like companies with higher ROEs.

“ROE is a way to think about how much money you are getting back from an investment,” says Mike Bailey, director of research at FBB Capital Partners in Bethesda, Maryland.

To illustrate, he uses the example of buying a pizza parlor for $100,000. If you only make $5,000 after expenses each year on your parlor, your return on equity is 5%. If, however, you make $30,000 in annual profits, you’re looking at a much better ROE.

[See: 10 of the Best Investing Books for Beginners.]

Why Is ROE Important?

“ROE tells you how good or bad management is doing with your investment,” Bailey says. “Higher ROEs generally stem from profitable businesses that enjoy competitive advantages within a given industry.”

Investors can use ROE to compare a company with its peers. “If your pizza parlor is only making $5,000 a year, and similar restaurants are making more, then perhaps your manager is mediocre,” he says.

“Similarly, if Coke (ticker: KO) has a lower ROE than Pepsi ( PEP), investors should ask Coke tough questions about how management can improve.”

How to Calculate ROE

To calculate ROE, all you need is a company’s income statement and balance sheet, both of which can be found in the annual report filed with the Securities and Exchange Commission or on most websites that provide analyst ratings, like Morningstar. These sites may also provide the ROE for you, but it helps to know how to calculate it yourself.

The ROE formula is net income divided by shareholders’ equity. So the first step to calculating ROE is to find the company’s net income (or loss) for the period. This will be the last line on the income statement.

Next, move over to the balance sheet to calculate shareholders’ equity, which is total assets minus total liabilities. Then all you need to do is divide net income by the shareholders’ equity you just calculated. This is the company’s return on equity.

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What Is a Good Return on Equity?

“Generally, we prefer to look for companies that can generate a return on equity that exceeds other investment alternatives when considering the riskiness of the investment,” Bailey says. “At the moment, a risk-free investment in 10-year Treasury bonds will return you a little less than 1% a year.” Comparatively, a basket of slightly riskier blue-chip corporate bonds, as measured by the Bloomberg Barclays US Aggregate Bond Index, may get you just less than 3% a year.

“Stocks need to offer an even higher return, since they have greater risk than Treasurys or corporate bonds,” he says. “Because stocks have historically generated a high-single-digit annual return, we generally look to own stocks with at least a 10% return on equity looking into the future.”

ROEs can vary depending on how much debt the business has. A company with a lot of debt could present as one with a high ROE.

“A pizza parlor can borrow money, expand and sell more pizzas, which may look great from a return on equity perspective,” Bailey says. Since this can be deceptive, he suggests using return on debt plus equity, called return on capital, for companies with a high debt burden.

Another consideration is that “most calculations of ROE focus on the book value of equity, which is like saying the value of a house today is equal to the original purchase price, rather than what a current buyer would pay today,” Bailey says. “If the last time a company issued stock was many years ago, this may understate the company’s equity value. Because of this, we prefer to use the market value of equity, or market capitalization, to calculate ROE.”

ROEs also vary across industries, so a good ROE in one industry may be a lackluster one in another. Even industries within the same stock market sector can have different ROEs.

[READ: The Ultimate Guide to Equity.]

“For example, Mastercard, which has a high market share in the fast-growing payments industry, generates 100%-plus ROEs, whereas banks, which offer a pretty commoditized product, generate ROEs in the high-single-digit to low-double-digit range,” Bailey says. He looks for companies with ROEs above their peer group within an industry.

“Alternatively, we might own a turnaround where ROE looks terrible today, but in a few years the ROE could meet or exceed the industry average,” he says. “This approach is similar to buying the worst house in a good neighborhood and fixing it up.”

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What Is Return on Equity: The Ultimate Guide to ROE originally appeared on usnews.com

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