As an investor, you want to make sure that your money is being spent wisely. Some companies do better with investment capital than others do, and knowing your money is going to be well-spent is a great incentive to invest in that particular business. This is where “return on equity” comes in.
Return on Equity Definition
Return on equity can be defined as the amount of profit made off of investor’s money. It’s listed as a percentage which literally shows how much income a company makes off of each dollar invested in the business.
Return on Equity is calculated by the simple formula
Return on Equity = Net Income/Shareholder’s Equity,
where “net income” refers to company profit, and “shareholder’s equity” refers to the amount of money retained and invested in the business.
So, if Company A generated $5 million dollars in income, and at the same time took in $10 million from shareholders, that would give Company A a Return on Equity of 50% ($5 million, divided by $10 million).
Meanwhile, if Company B generates $5 million, but took in $20 million in shareholder money, it’s ROE would only be 25%.
Why is Return on Equity important?
All in all, it’s a measure of efficiency. What ROE really tells you is how much bang for your buck you’re getting when you invest in a company. A company with a high ROE is more likely to put money back into your pocket in the long run, which makes it a more solid investment.
Of course, it’s a little more complicated than that. Companies in different sectors of the market will have different ROEs, so you can’t compare the ROE of a tech stock with that of a bank; it’s a little like comparing apples and oranges. This is why good research is crucial, as it will tell you what a good ROE is for the type of stock you’re looking to buy.
You should also know that it is actually possible for companies to artificially inflate their Return on Equity. Since it’s calculated based on shareholder’s equity, things like write-downs and buybacks, which lower the value of shareholder equity, will actually boost the ROE. A high level of debt can also boost a Return on Equity. Once again, research is important. Finding a company with a high ROE is great, but make sure it’s an earned number before you buy.