(January 12, 2010) Most of us think that earnings of a company are a sufficient to find out whether it is worth investing or not. But this is not true. Any company can inflate earnings through cost cutting measures, selling its assets or by pumping in more equity in business. What really matters is that how much does a company offer on capital invested. This measurement is known as return on equity or (ROE). ROE is an accurate barometer which show how efficient is the company’s management in employing shareholders’ capital. Typically, a ROE of at least 15% is considered as a good return. Therefore, investors can always look at this rate before investing; if it is 15 % or above then stocks indicate a green signal for investing.

Calculation: The ROE can be calculated by using following formula: Net Income/ Shareholders’ equity.

Another benefit arising out of the ROE is that this ratio offers an insight on financial success of the firm; since it might indicate whether the company is increasing profits without acquiring new equity capital into the business.

ROE limitations

Sometimes, simply looking at the ROE to gauge a company may not give us the complete information. The ratio does not give us an idea to an extent the company has long term debts. Let’s understand it trough an example: consider two companies ABC and XYZ. Both companies ABC and XYZ have long term liabilities (capital) of $1000. Both companies have earned same amount of profits during a financial year, say, $150. But the capital structures of both companies are different. Company ABC has $600 of shareholders’ equity and $400 of debt. Company XYZ has a shareholders’ equity of $800 and a debt of $200. Computing for the ROE ratio for both companies give us ROE of Company ABC as 25% and for company XYZ, the ROE is 18.75%.  

Now, given an option to choose one company to invest, investors will be tempted to buy the stocks of Company ABC as it has higher ROE. But think about it more deeply; we will find that a higher ROE is a result of higher debt which dilutes the denominator (shareholder equity). Even though company ABC has higher profitability it has more debt obligation towards the creditors which ROE does not reveal. It also means that ABC relies on borrowed funds to generate the same level of profits.