In previous posts I’ve written about market capitalization and the P/E ratio, and the basics of the stock market. Today I want to introduce another concept used to analyze a company to determine whether you’d like to invest in it.

Return On Equity (ROE) is a measure of a companies ability to profitably employ the money that shareholders have invested. This measure is calculated as follows:

ROE = Net Income / Shareholder’s Equity

A company’s net income may be obtained from the income statement while the shareholder’s equity is reported on the balance sheet. You don’t actually need to calculate this yourself, though, since many financial sites such as Morningstar will provide it for you.

So, now that you have this number, what does it mean for you? Like I stated earlier, it measures how profitably a company employs its investors money. It should be obvious that the higher this number the better; however, there’s a little more to it than that.

Say a company has an 18% return on equity (General Electric is one example). Let me be clear now; this does not mean that you will earn 18% on the money you invest. If you remember from an earlier post, when you buy a stock, you’re buying it on a secondary market, and it has no effect on the company’s financials. What you are doing is buying an ownership interest in the company that then entitles you to any FUTURE earnings and growth.

This is where the 18% ROE comes into play. Now that you own a few shares of a company, the company will hopefully post a profit from which you determine what’s called Earnings Per Share (EPS). These earnings belong to you as the shareholder. The company now has to make the choice of what to do with these earnings.

There are a few main options. The company may announce a dividend, in which case you will be paid out a portion of these earnings. The company may choose to buy back it’s own stock with these earnings (a topic for another day), or it may choose to reinvest the earnings back into the company which is what we call retained earnings.

It is this last option that we are interested in when we talk about Return On Equity. Based on our example of an 18% ROE, we can expect the company to earn an 18 percent return on this reinvested capital. It is this compounding year after year of profitably retained earnings that can make one wealthy.

There is an upfront cost to get into a stock because of the current market valuation. Looking back at the P/E ratio, if a company trades at 20 times earnings and has earnings of $2 a share, you can expect to pay about $40 per share. If you buy this stock, you can view the earnings as your return on your investment, in this case $2 / $40 = 5%. This doesn’t look like anything spectacular, but it’s the $2 in earning that will compound at the 18% Roe.

In the second year you could reasonably expect earnings increase to $2.36 (2 x 1.18 = 2.36). This then increases your return to 5.9% (2.36 / 40 = 5.9%). After 10 years of the earnings compounding, your $40 initial investment is now returning over 26%.

Obviously there are assumptions being made such as a sustainable ROE and earnings growth and the like, but it’s the concept that I want you to understand. It’s another tool to put in your financial toolbox. Hopefully, this has provided some insight into the investment world and will help you in the future.

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