Return on Equity
A publicly traded company (any company that issues shares to the public) is owned by its shareholders. Return on equity calculates the amount of profit for every $1 the shareholders invested.
How to use return on equity
10% return on equity means the company generated $0,1 for each $1 the owners (shareholders) invested.
- Higher is better.
- Above 15%-20% is considered healthy but always compare the company to the industry mean.
- Can be very different between industries.
- Can be used to compare companies.
Why do investors use return on equity in their analysis
To find out the owners/management's attitude toward their company. You typically want the owners/management to invest in the company and focus on generating profit. If not enough profit is generated (compared to the industry mean), the company might not be investing their money efficiently.
The three steps every investor should look at:
- What is the current return on equity?
- How does it compare to the industry?
- What is the trend?
Things to be aware of
- Only compare with other companies in the same industry.
- Does not include intangible assets (non physical assets like licences, computer software, etc.).
- Stockholders equity and shareholders equity refer to the same thing.
- Liabilities should not be more than three times return on equity.
How to calculate return on equity
Real example of Tesla
A real life example of Tesla. You need the following data to determine ROE:
- Return on equity = net profit / shareholders equity
- $2,259,000 / $36,376,000 = 0.062 * 100% = 6.2%
Tesla generated $0.062 for each $1 the owners invested
A negative shareholder equity is a warning sign. It means the company has more liabilities than assets. It might also mean that the owners did not invest enough money or they are taking money out of the business. Don’t stare too much at lower numbers. $0,06 does not seem much but this totally depends on the industry and other factors. You should always compare these numbers with other companies in the same industry.
I already calculated the return on equity for each company and compared them with the industry average. Use the search bar on top, fill in your favorite company and find out how they perform.
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