One way to invest money is by buying stocks and, because there can be so many choices of stocks to consider, investors may find themselves comparing one option to another—yet still being uncertain about what’s the best decision.
So, what is the best way to compare a variety of stock buying options? One commonly used method is a ratio called the return on equity. Another name for this ratio is “return on net worth.”
The Return on Equity Formula
This formula is a fairly straightforward calculation that can provide a key comparative metric to investors. The ratio helps them to determine how well a particular company is managing contributions from their stockholders—and then they can compare that result to the ratio of another company, and so forth.
Return on Equity = Net Income/Average Shareholder Equity
The higher the number, the more efficiently the company’s management is likely generating growth from the money invested.
Here are the nuts and bolts of the calculation and definitions for relevant terms.
How to Use the ROE Formula
Calculating return on equity requires two pieces of information: net income and shareholder equity. Once this information is at hand, divide net income by the shareholder’s equity—and the result is the return on investment ratio.
So, how can those numbers be found?
Net income, also called “net earnings” or the company’s “bottom line,” is a figure that’s included on a company’s income statement. The income statement is also called a P&L statement or profit and loss statement.
Publicly traded companies are legally required to distribute income statements in their annual financial reports to shareholders. Many companies may choose to also include financial statements on their websites and may otherwise distribute this information. So, when calculating return on investment, the net income figure can usually be found through one of these methods.
Reverse Engineering Net Income
Net income is calculated by taking the amount of a company’s sales and then subtracting what’s called the “cost of goods sold” from the figure.
Cost of goods sold, in turn, is calculated by determining the direct costs of making products, which includes the cost of materials used and direct labor costs. It does not include indirect costs, such as marketing.
Subtract the costs of goods sold from the sales total—and then also subtract operating expenses, administrative expenses, taxes, depreciation, and so forth. What’s left is a company’s net income.
Reverse Engineering Stockholder Equity
This can also be called “shareholder equity.” This information can be found on a company’s balance sheet and the formula for shareholders’ equity is as follows: total assets minus total liabilities = SE—so, it’s what a company owns minus what it owes.
As another way to look at this, if all of a company’s assets (buildings, equipment, investments, and so forth) were liquidated into cash and all debts were paid off, what remained would be shareholder equity.
How to Use Return on Equity Ratios to Invest
Here’s an example. If a company has $5 million in net income, with shareholder equity of $15 million, then return on equity can be calculated in this way: $5,000,000/$15,000,000 = 33.3%.
Using this figure as a benchmark, an investor can then compare the desirability of buying stocks from this company versus those available from another company.
When calculating the ROE ratio, an investor gains visibility into a moment in time. Investors may choose to do that before buying or selling shares—or they may track the performance of a stock over a period of time.
Some of these investors like to see the return on equity calculation rise by 10% or more each year, as a reflection of the S&P performance.
In general, when ROE rises, it means the company is generating profit without needing as much capital—meaning without needing as much influx of cash. It demonstrates that the company is efficiently using the capital invested in the business by shareholders. When the ratio goes down, it is generally a sign of a problem.
This, however, is not universally true. There are times when return on equity artificially goes up. This can happen if a company buys back shares of its own stock or if the company has a significant amount of debt. So, although ROE is a key metric for investors to use when deciding if a particular stock is a worthwhile investment for them, it’s not a stand-alone metric.
Here are a few additional factors to consider. Because some industries as a whole typically have higher ROE ratios than others, comparisons between companies are more meaningful when done between two companies of the same industry.
Plus, in general, the more risks taken in investment choices, the higher the potential for return, as well as for loss. So, some investors with a higher tolerance of risk may choose to buy shares of stock in companies that don’t look as desirable if they have reason to believe that there is enough potential for significant financial rewards.
What Else to Consider with ROE
When buying shares of stock, an investor is buying ownership shares of the company. So, when the company does well, the stockholders typically benefit. When all goes south, the stockholders usually lose out.
This means that, when an investor knows a reasonable amount of information about the company and the industry it’s in, as well as its financial structure, better investment choices can typically be made. Other factors that influence the investor during the decision making process include the economy, customer profiles of a business, and more.
To glean these types of insights, savvy investors often look at financial reports and figures, in addition to return on equity, when choosing how and where to invest.
First, here’s more about the financial reports that the Securities and Exchange Commission (SEC) requires public companies to file.
These need to be filed quarterly and they can provide insights into the companies’ financial performances.
Experienced investors often take their time reviewing documents of companies that interest them; here is an overview of important information that can be found in the different types of financial documents:
• Income statement: This document provides an overview of a company’s revenue (cash coming in), expenses of significance (cash going out), and the bottom line (the difference between what’s coming in and what’s going out); what trends exist?
• Balance sheet: Look at the company’s debt (how much they owe). Is the amount going up? Down? In what ways? What can be learned about the company’s financial performance from this review?
• Cash flow statement: What did the company actually get paid in a particular quarter? This is different from what is owed (accounts receivable) and focuses on when the cash arrives to the company. Does that company have steady cash flow?
Investors typically look at a company’s after-tax income (its “earnings”), which can be found in quarterly and annual financial statements. In addition to looking at the company’s current earnings, it can make sense to review its history to see how much earnings have fluctuated and whether there is a pattern to these fluctuations.
Overall, good earnings indicate that the company is profitable and may be a good investment to consider.
Another figure to consider reviewing is a company’s operating margins (also known as its “return on sales”). This indicates how much a company actually makes for each dollar of its sales.
This calculation involves taking the company’s operating profit and dividing it by net sales. Higher margins are typically better, and may indicate good financial management.
Now, here are other financial ratios to consider, besides the return on equity ratio:
• Price-to-earnings ratio: This allows investors to compare stock prices between companies offering shares. To calculate this ratio, take the market price of a share of stock and divide that number by the amount of earnings that a company is paying per share. This ratio allows investors to see how many years a company may need to generate enough value for a stock buy-back.
• Price-to-sales ratio: This can be a good metric to use when reviewing a company that hasn’t made much of a profit yet—or one that’s made no profit at all, so far. To calculate this, take the value of the company’s outstanding stock in dollars and divide that number by the company’s revenue. The resulting figure, ideally, should be as close to one as possible. If the number is even lower, this is an outstanding sign.
• Earnings per share: This metric helps investors to know how much money they might receive if the company liquidated. So, if this number is consistently going up, this may entice more people to buy shares because this at least suggests that they’d get more for their investment dollars if liquidation happened. Earnings per share can be calculated by taking the company’s net income and then subtracting a certain type of dividends (preferred stock) and then taking that figure and dividing it by the number of outstanding common stock shares.
Preferred stocks don’t have voting rights attached to them like common stocks do, but they received a preferential status when earnings are paid out.
• Debt-to-equity: Investors use this metric to try to determine the degree that a company is using debt to pay for its operations. To calculate this figure, take the company’s total liabilities and then divide that number by the total shareholder equity. A high ratio indicates that the company is borrowing to a significant degree.
• Debt-to-asset ratio: Investors may decide to compare debts to assets of a company—and then compare the resulting ratio with other similar companies to determine how significant a debt load a company. It may be wise to calculate this within the context of a particular industry.
What Is a Good Rate of Return?
First, consider that, when cash is kept under the mattress at home, the rate of return is zero percent. And, when factoring in inflation, this means the person is actually losing money over time. Keeping money in a checking account can amount to virtually the same thing.
There is no guaranteed return on investment in stocks. That’s because of variations in the market, varying degrees of risk taken by investors, and so forth. There are, however, historical precedents that indicate how stock ownership over the long haul can often allow the investor to weather economic fluctuations for an ultimately positive result. And, when looking at the average annual return on investments for stocks since 1926, that number has been 10.1%.
A topic mentioned in this post has been risk tolerance. This is the amount of risk that a particular investor is comfortable taking and here is a quiz to help investors determine their own levels of risk tolerance.
Factors to consider when determining how much risk to take include:
• Financial factors: How much could a person afford to lose without it having a negative impact on financial security? When people are young, they typically have much more time to recover from a big market loss, so they may decide that it’s okay to be more aggressive. People closer to retirement age, though, may decide to be more protective of their assets. It’s important to review current financial obligations, from mortgage payments to college tuition, to make an informed decision, as well.
• Emotional risk: Some people feel energized when taking risks while others feel stressed. A person’s emotional responses to risk taking can play a key role in their risk tolerance when investing.
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