As a shareholder, you’re part-owner of a business, but you still don’t get to sit down with the CFO and ask where your money is being spent.
Luckily, there is a metric known as Return on Equity (ROE) that gives you a pretty good idea of how the top brass is handling your cash.
ROE tells you how effective a company is at using shareholder capital (the money you gave in exchange for stocks) to generate profits.
Return On Equity = Net Income ÷ Shareholder Equity
ROE is especially useful for comparing the profitability of companies in the same industry, like Coke (KO) and Pepsi (PEP) or American Eagle (AEO) and Abercrombie (ANF).
Anywhere between 15% to 20% ROE is considered good and that’s what we aim for when looking for companies to invest in. This means that for every dollar invested, the company generated 15 to 20 cents in profit.
But high ROE doesn’t have any immediate benefit. The benefit comes from a company with a high ROE rate reinvesting their earnings back into the company. This, in turn, gives the company a high growth rate, which is what you want to see as a shareholder.
When researching a company, if you find a CFO bragging about “record earnings” in a year, it’s smart to check their ROE as well. That will tell you not just how much more the company is bringing in, but also whether or not management is playing smart with reinvesting those increased funds.
To sum up:
- Return on Equity (ROE) tells you how well management is using investors’ money.
- Anywhere between 15% to 20% ROE is considered good.
- ROE is useful for comparing companies in the same industry.
MyWallSt operates a full disclosure policy. MyWallSt staff currently holds long positions in companies mentioned above. Read our full disclosure policy here.