Over this week and next week, TheStreet.com is running a series on executive compensation vs. corporate performance. As the measure for corporate performance, we have used return on equity, hence the title: ROE v. Paid. ( click here to read the introduction to the series.)

With that in mind, it's a good idea to explain the basics of return on equity, why we think it's a better barometer for executive performance and why gurus pay so much attention to it.

"The primary test of managerial economic performance is the achievement of a high earnings rate on equity capital employed (without undue leverage, accounting gimmickry, etc.)," wrote Warren Buffett in a 1983 letter to shareholders.

In The Warren Buffett Way, Robert Hagstrom, who also manages the ( LFOCX) Legg Mason Focus Trust fund, listed this as Buffett's first tenet in analyzing a company: "Focus on return on equity, not earnings per share."

What It Is

Return on equity, or ROE, measures how well a company uses shareholder money to generate additional earnings. It is easy to calculate and a useful way to measure companies against their industry peers. To get a company's ROE, divide annual net income by average shareholder equity, and multiply the number by 100%. So, if net income is $500 and equity is $2,500, the company has a 20% return on equity.

The Quirks

No single measure of corporate performance is perfect, and ROE has its kinks. First, a high return on equity doesn't tell you if a company has a high debt level -- especially if a company raises more of its funds through borrowing than issuing new shares. Also, while ROE may be a little less vulnerable to accounting legerdemain than quarterly per-share earnings numbers, no number is impervious to the games played by companies like Enron and WorldCom.

Also, to avoid a one-year anomaly, it is preferable to look at five-year average return on equity. (If you can't get your hands on a Bloomberg terminal or another data box, don't fret: Next week, I'll list a chart with the five-year ROE of all S&P 500 companies.)

The Over-Under Line

While it varies a bit depending on which industry you are examining, a decent unofficial yardstick for good return on equity is 15%.

The tome Business: The Ultimate Resource says: "Return on equity for most companies certainly should be in the double digits; investors often look for 15% or higher, while a return of 20% or more is considered excellent."

Or, to pluck a quote from my recent interview with Lanny Thorndike, the savvy manager of the ( CSMVX) Century Small-Cap Select fund, "if companies can't deliver above 15% return on equity over rolling three-year periods, those generally aren't the stories that interest us."

The Wheat From the Chaff

While no one measure gives you the perfect comparison between companies, contrasting the five-year ROE within certain sectors highlights fundamental differences between competitors and how well they deliver on shareholder equity. Consider the PC business.

Everyone knows Dell's ( DELL) ultra-efficient direct-selling strategy and second-round entry into industries with high profit margins has paid off in terms of earnings and stock appreciation compared with rivals such as Hewlett-Packard ( HWP) and Gateway ( GTW).

The return-on-equity figures drive home the point especially well. Dell's five-year return on equity is an astonishing 46.6%, compared with Hewlett-Packard's 11.9% and Gateway's negative 2.8%.

Likewise, Cisco Systems ( CSCO) sports a 12.4% five-year average return on equity. While that falls a bit under the 15% yardstick, it's outstanding compared with rivals such as Ciena ( CIEN) and JDS Uniphase ( JDSU), whose five-year ROE tallies minus 37.5% and minus 94.6%, respectively.

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