Return on Equity = ROE
Return on Equity is a term that you will hear a lot when talking about finance and investments. It is a simple calculation and view of a company’s growth. Return on Equity is sometimes also called Return on Net Worth. The reason being is that Equity is also Net Worth/Net Income. Return on Equity is expressed as a percentage.
Warren Buffett says Return on Equity is one the most important tools available to measure a company and managements efficiency.
This reason is because it is only measuring the performance of the company. Return on Equity does not account for the stock’s performance. This is helpful because that means any company can utilize this metric. A company doesn’t need to be publicly traded on the markets to get this measurement. All companies, big and small, public or private, can generate a ROE calculation.
ROE = Company Profit or Net Income DIVIDED BY Shareholder Equity
Net Income is defined as the profit that a company generates. This amount is calculated after all expenses but before dividends are paid out to common shareholders.
Shareholders Equity= Assets MINUS Liabilities
ROE and Business Growth
Return on Equity will tell how the business is growing. It is good to compare ROE to company’s that are similar. It will tell how one is growing versus the other and measuring the performance is key for investors. ROE is a good test to see if a company is truly growing at a respectable rate. Also, to think long term and ignoring the fluctuations of a company’s stock price.
When determining the growth of a company, ROE is a good place to look. For example, if a business adds no additional debt or assets from the year before and their profits increase, then Return on Equity will also increase. What does this mean? This could show that the company is using those same assets more efficiently than before. This results in a good thing for the investment.
On the other hand, there is a pitfall to Return on Equity to keep an eye on. For example, if a company takes on debt, equity shrinks, and profits stay the same. This will result in ROE increasing and not because of improvements in efficiency. More debt = lower equity.
Tips from Warren Buffett
In 1977, Warren Buffett wrote in his letter to shareholders about ROE. He said to beware of companies with strong Return on Equity, if they also have high debt to equity ratios. Having a high debt to equity ratio implies that the company’s ROE is likely higher because they took on more debt.