Return on Equity (ROE) and Income Statement Analysis

Investing Lesson 4 - Analyzing an Income Statement

By Joshua Kennon

One of the most important profitability metrics is a return on equity, or ROE for short. Return on equity reveals how much after-tax profit a company earned in comparison to the total amount of shareholder equity found on the balance sheet. If you think back to lesson three, you will remember that shareholder equity is equal to total assets minus total liabilities. It's what the shareholders "own".

Shareholder equity is a creation of accounting that represents the assets created by the retained earnings of the business and the paid-in capital of the owners.

The Reason Return on Equity Is Important

A business that has a high return on equity is more likely to be one that is capable of generating cash internally. For the most part, the higher a company's return on equity compared to its industry, the better provided it isn't achieved with extreme risk. This should be obvious to even the less-than-astute investor If you owned a business that had a net worth (shareholder's equity) of $100 million dollars and it made $5 million in profit, it would be earning 5% on your equity ($5 $100 = .05, or 5%). The higher you can get the "return" on your equity, in this case, 5%, the better. In fact, the key to finding stocks that will make you rich in the long-run often involves finding companies capable of generating a sustained, outsize return on equity over many decades and acquiring it at a reasonable price.

The Formula for Calculating Return on Equity

The formula for Return on Equity is:

Net Profit Average Shareholder Equity for Period = Return on Equity

An Example of a Return on Equity Calculation

Take a look at the same financial statements I've provided from Martha Stewart Living Omnimedia at the bottom of the page.

Now that we have the income statement and balance sheet in front of us, our only job is to plug the numbers into our equation. The earnings for 2001 were $21,906,000 (because the amounts are in thousands, take the figure shown, in this case, $21,906, and multiply by 1,000. Almost all publicly traded companies short-hand their financial statements in thousands or millions to save space). The average shareholder equity for the period is $209,154,000 ([$222,192,000 + 196,116,000] 2]).

Let's enter the numbers into the return on equity formula.

$21,906,000 earnings $209,154,000 average shareholder equity for period = 0.1047 return on equity, or 10.47%

This 10.47% is the return that management is earning on shareholder equity. Is this good? For most of the twentieth century, the S&P 500, a measure of the biggest and best public companies in America, averaged ROEs of 10% to 15%. In the 1990's, the average return on equity was in excess of 20%. Obviously, these twenty-plus percent figures probably won't endure forever unless you believe that productivity increases brought on by technology have fundamentally altered the economic paradigm the same way the industrial revolution permanently shifted the productivity baseline.

Return on equity is particularly important because it can help you cut through the garbage spilled out by most CEO's in their annual reports about, "achieving record earnings". Warren Buffett pointed out years ago that achieving higher earnings each year is an easy task. Why? Each year, a successful company generates profits. If management did nothing more than retain those earnings and stick them a simple passbook savings account yielding 4% annually, they would be able to report "record earnings" because of the interest earned. Were the shareholders better off? Not at all. They would have enjoyed heftier returns had the earnings been paid out as cash dividends. This makes obvious that investors cannot look at rising per-share earnings each year as a sign of success. The return on equity figure takes into account the retained earnings from previous years, and tells investors how effectively their capital is being reinvested.

Thus, it serves as a far better gauge of management's fiscal adeptness than the annual earnings per share in isolation.

Variations in the Return on Equity Calculation

The return on equity calculation can be as detailed as you desire. Most financial sites and resources calculate return on common equity by taking the income available to the common stockholders for the most recent twelve months and dividing it by the average shareholder equity for the most recent five quarters. Some analysts will actually "annualize" the recent quarter by simply taking the current income and multiplying it by four. The theory is that this will equal the annual income of the business. In many cases, this can lead to disastrous and grossly incorrect results. Take a retail store such as Lord & Taylor or American Eagle, for example. In some cases, fifty-percent or more of the store's income and revenue is generated in the fourth quarter during the traditional Christmas shopping period. An investor should be exceedingly cautious not to annualize the earnings for seasonal businesses.

If you want to really understand the depths of return on equity, you need to open a new browser tab, leave this lesson in the background, and go read Return on Equity - The DuPont Model. That article will explain the three things that drive ROE and how you can focus on each one to increase your business or determine the source of growth in another company; e.g., you could figure out if recent improvements in profits were due to ?the rising debt levels instead of better performance by management.