Using Return on Equity (ROE) to Gauge Financial Success

Return on equity is a valuation multiple that is commonly used to determine the value of a company. Investors will rely on return on equity to tell them important information about a company's potential. Here are the basics of return on equity and why it is important.

Return on Equity

The process of determining return on equity is very simple. Take the net income after taxes and divide that by the shareholder equity. This is designed to tell you exactly how much profit can be generated by the company when people invest in it.

Why it is Considered Valuable

Many analysts believe that return on equity is one of the best tools that you can use to determine the value of a company. This metric tells you exactly how much profit is being generated when money is invested in the company. They can break it down on a dollar for dollar basis. The principle is that if you invest one dollar with the company, the shareholders are going to receive a certain amount of money in shareholders' equity.

By determining this information, you can see how efficient a particular company has been. Ideally, you would like to invest in companies that are very efficient and can generate large amounts of profit with minimal inputs. Companies that have been good stewards of shareholder investments bring in good returns for those investors. If a company does not have a good return on equity, they are not considered to be efficient. Investors should then avoid putting more money into these companies because they do not necessarily handle it well.

What to Look for

If you have been tracking a particular stock for a certain amount time, you would like to notice a pattern developing. It's a good sign if the company's return on equity has been steadily increasing. You want to see companies that increase their return on equity because it shows you that they value the shareholders. They are providing steadily more returns for the investors and rewarding them for investing in the company.

Cautions

Even though this calculation can be extremely useful, there are a few things that you need to watch out for. This number can be significantly manipulated by companies that are trying to improve their return on equity. When the shareholder equity is decreased it will increase the amount of return on equity. Therefore, a company could potentially increase their return on equity by buying back a certain number of shares of stock from the market place.

The company could also use a write-down to decrease the amount of shareholder equity. This is done when a particular asset is lowered in value to keep up with market influences. 

Another problem with return on equity is that intangible assets are not calculated into this measurement. Aspects like patents and intellectual capital cannot be accounted for with this method.

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