Analysis of the Return on Stockholders' Equity Ratio

Original post by Matt Petryni of Demand Media

Analysis of return on equity is one tool investors use to evalutate investments.

Hemera Technologies/AbleStock.com/Getty Images

Investors who buy stock for the long term are usually most interested in an investment's profitability. Understanding how to analyze an investment's ability to deliver returns is essential, even for investors with professional financial planners. It's also important for investors to know about the ways in which their analysis may be limited.

Return on Stockholder's Equity

Return on stockholder's equity is calculated by dividing the total net income available to common stockholders by the total value of the stockholder's equity. Return on stockholder's equity -- or simply, return on equity (ROE) -- is a profitability ratio. In most cases, businesses will be managed with the intention of maximizing its return on stockholder's equity.

Analysis for Profitability

Return on stockholder's equity is an important ratio for investors to analyze. According to the NASDAQ stock exchange, "ROE gives us a glimpse into how efficiently company management is producing a return for the owners of the company -- based on the amount of equity in the company." ROE is often used as a measure to compare one company to another -- those with higher ROE are generally better managed. It also sometimes provides a helpful screening tool, used by investors to establish a minimum level of profitability they're interested in.

Analyzing for Earnings Growth

In addition to current profitability, ROE speaks to the company's future growth potential. Firms generally cannot grow their earnings in excess of their ROE without raising additional capital from new investors, or from raising debt. Because of this, "ROE is, in effect, a speed limit on a firm’s growth rate, and that’s why money managers rely on it to gauge growth potential," according to investment analyst Harry Domash. This feature allows ROE to serve as both an evaluation tool to score the effectiveness of an investment strategy, and as a forecasting tool for profit potential in the future.

Limitations

Analyzing ROE has some limitations for investors. Firms often borrow money to help finance their operations. But because borrowing is more expensive than attracting investors, a heavily leveraged firm is generally a riskier investment than one that relies more on investment capital for financing. Despite this, it will have a higher ROE because ROE increases as stockholder's equity increases. This could make the firm appear more profitable than it actually is, so it's important to consider the company's liabilities when analyzing ROE. Additionally, ROE is often subject to inflation, which might further distort the long-term picture.

Resources

• James Madison University; Financial Ratio Analysis; Pamela Peterson Drake
• "Journal of Finance"; The Cross-Section of Expected Stock Returns; Eugene Fama and Kenneth French; 1992

References

• AccountingCoach Blog; What Is The Return On Stockholders’ Equity (After Tax) Ratio?; Harold Averkamp; 2011
• Cengage Learning; The Role of Financial Analysis; 2010
• NASDAQ; Return on Equity (ROE) - The NASDAQ Dozen; 2011
• "Financial Services Review"; The Impact of Inflation on ROE, Growth and Stock Prices; Frank Reilly; 1997
• WinningInvesting.com; Focus on Return on Equity (ROE); Harry Domash; 2002
• "Excellence in Financial Management"; Evaluating Financial Performance; Matt Evans; 2000

About the Author

Matt Petryni has been writing since 2007. He was the environmental issues columnist at the "Oregon Daily Emerald" and has experience in environmental and land-use planning. Petryni holds a Bachelor of Science of planning, public policy and management from the University of Oregon.

Photo Credits

• Hemera Technologies/AbleStock.com/Getty Images