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.
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%.