TheStreet

If you have even a passing interest in investment you'll have seen the term "return on equity." This is a core measure of a company's financial strength, but it isn't always explained in market watching articles.

For readers who would like to understand the market a little better, then, this is what you need to know about this investor's term.

What Is Return on Equity?

Return on Equity (RoE) measures a company's profitability, specifically the firm's net income (its annual return) divided by total shareholder equity. The result is expressed as a percentage that shows total profit per dollar of overall assets.

Let's be honest, if you came here looking for a better understanding of finance, that description probably didn't help much. If anything it only made matters worse. We understand that we're a few sentences away from driving you to an art history degree, so let's break this down a little more.

First, an example of an RoE calculation. Car Company had $1,000 in net income last year and shareholder equity worth $5,000. This means that its return on equity would be: $1,000 (net income) / $5,000 (shareholder equity) = 20%.

For every dollar of overall assets that Car Company had last year it saw a return of 20 cents.

How Return on Equity Works

Here's how that works:

Net Income

Net income is a firm's profit after it pays and accounts for all of its annual liabilities. This includes line-items such as taxes, salaries, cost of goods and products and other operating expenses. It also includes more subtle forms of loss and liability such as depreciation and interest rates.

After accounting for all of these losses and liabilities, the firm's remaining annual profits are its net income for the year. In a nutshell, how much money did we make?

Total Shareholder Equity

Shareholder equity is the total value of the firm's assets minus its liabilities. This is a comprehensive accounting. Assets include essentially everything that the firm owns, including cash or cash-like products and the value of property like physical infrastructure, real estate, investments, intellectual property and any other corporate holdings. Liabilities include both short term liabilities, such as payroll and immediate debts, as well as long term liabilities such as bonds, mortgages (where applicable), retirement funds and any other form of corporate expense.

Readers will note significant overlap between net income and shareholder equity. In simplified terms, net income is earnings against expenses for a given year. Shareholder equity is the value of the firms total assets and debts.

In Summary

The RoE, then, is a comparison of how much money a firm makes with each dollar of overall assets that it has. In our example above, Car Company makes 20 cents back for every dollar that the company owns.

Why Does Return on Equity Matter?

Return on equity is used chiefly to evaluate corporate strength and efficiency. It's a measure of overall profitability, and of how well the company's leadership manages its shareholders' money.

Expressing it as a percentage allows investors to evaluate this in the absence of distorting numbers. For example, a retailer might show huge sales numbers and may even use tricky accounting to turn that into millions of dollars of net income in a given year. In a vacuum, then, those numbers might make an ailing company look good.

Return on equity lets an investor break that income down by how much money it took to build that book of business. That retailer perhaps might show millions of dollars in net income, but might spend hundreds of millions of dollars to generate those sales. That business model looks much less healthy when held under a microscope.

Our Car Company, by contrast, shows a healthy return of 20% for every dollar that a shareholder puts into it.

It's important to compare return on equity across comparable businesses and industries. Retail, which we noted above, is traditionally a relatively high-performing industry. A store with an RoE of 10% would perform poorly compared to similarly situated competitors. By contrast, though, a 10% RoE would put a bank right around the midrange for its industry.

How to Use Return on Equity in 3 Ways

We could write a book on this subject, and people have, but there are a few general topics you should consider when applying return on equity.

1. Dividend Payments

A high return on investment is generally a strong indicator of a firm that can pay dividends to investors. While this is not necessarily a sign of what the firm will choose to do, the RoE of a well-performing firm can indicate if it has the capital to make shareholder payments.

2. Growth

Generally speaking, RoE indicates how quickly you can expect a company (and therefore your return on any investment in that company) to grow. Many investors use what is called the retention ratio to estimate future growth of a firm. This ratio is the percent of RoE that a company keeps for internal reinvestment after paying any dividends to shareholders.

Take our Car Company example again. It had an RoE of 20%. This means that last year the company generated an extra 20 cents for every dollar put into it. The board can then choose to return some of that money to the shareholders who put those dollars into the company in the first place. Whatever it does not return to the shareholders the company will keep for reinvestment in its growth.

Let's say Car Company chooses to return a dividend of 25%. Our retention ratio is then 75%. So we would calculate potential growth as a factor of retention against RoE:

Car Company Growth: 20% (return on equity) X 75% (retention ratio) = 15% anticipated growth

3. The DuPont Formula

DuPont chemical came up with a slightly more complicated way of assessing return on equity. Their formula is designed to help investors think about a company's profitability more clearly than the standard RoE formula allows for.

The DuPont formula calculates return on equity by comparing a firm's total profit margin against its sales turnover against its financial leverage. Here's the math:

Return on Equity = (Net Income/Sales Revenue) X (Sales Revenue/Total Firm Assets) X (Total Firm Assets/Shareholder Equity)

While this formula generally produces the same result as the classic return on equity approach, it can help an investor break down a company's performance more clearly.

The Excess Growth Problem

It's important to be careful of abnormally high return on equity for a firm's size and character, as well as for sudden spikes in an individual company's return. Both can be indicators of trouble.

Recall that the denominator of the return on equity formula is shareholder equity, the comparison of a firm's assets to its liabilities. If a company quickly loses assets or takes on a lot of debt, its shareholder equity will fall.

If sales and profits remain untroubled by this, the sudden drop in RoE denominator can cause the percentage to dramatically rise. That doesn't necessarily mean the firm is in good health though. It might mean anything from uninspired corporate restructuring to crippling future debt problems.

Can You Get a Negative Value for Return on Equity?

Finally, it's possible for RoE to return a negative value.

Under ordinary circumstances investors do not calculate a return on equity for firms with a negative net income, as in this case the return is zero. However, it's possible for a firm to have negative shareholder equity due to liabilities exceeding assets at a time of positive net income returns. In this case the RoE will turn negative.

A negative RoE is not necessarily cause to disregard a company altogether, but it should be read with great caution. In most cases negative shareholder equity signifies that the company has significant problems with debt, asset retention or both.

In some cases, however, this might be due to business developments. A firm which has taken out significant debt to launch an ambitious new project might generate negative RoE if it borrows more than the company is worth. Corporate restructuring that relies on stock buybacks, which involve massive outlays of cash, can do the same.

While these are both rare cases, they might signify a potentially strong future investment. In particular if the negative RoE is very high, it indicates strong net income against a low negative shareholder value.

Just be very careful before making an investment.