When choosing businesses to buy, one of the ratios we look at will be the Return on Equity.
Return on Equity measures the rate of return on business owner’s interest or equity.
Return on Equity = Net Income
Share Holder’s Equity
Each time a business makes profits, it can use it in a few ways.
- Issue profits out as dividends
- Retain the profits which adds to the Shareholder’s Equity
- Reinvest in itself by either expanding or buying back its own shares.
In other words, the profits which the business has made can either be issued to us, or kept by the business for continued operations or investments. If the business is keeping the profits, it is kept mainly as part of the owner’s equity and we want to know that this amount of money is put to efficient use. Return on Equity tells us how well this amount of money has been used.
For example, ABC company makes $100,000 this year and the amount of share holder’s equity it is holding is $5,000,000.
Return on Equity = $100,000 = 2%
$5,000,000
What?! We put or keep $5million with ABC company and it only made 2% or $100,000 out of it. That is simply not efficient and thus ABC company does not seem like a good place to put our money in. As a gauge, we should look for companies that have a consistent average ROE of 15%.
ROE is only one of the ratios we look at when we are checking a business’ track records. It is important to look at a few figures as a cross check to make sure that these numbers are not manipulated to fool investors.
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Mind Kinesis Research Team
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Investment in Stocks Blog
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