Return on Equity (ROE) – Investing Terms
Posted on | December 23, 2009 | No Comments
Return on Equity (ROE) is one of those fundamental concepts of investing. The principle is simple. What is the return on the stock holders equity invested in a company. As with almost everything else, there is an equation involved. ROE=Net Income/Shareholder’s Equity. Net income in this case is after Preferred shareholder’s dividends have been paid but before common stockholders dividends. Shareholder equity is common shares only, not preferred shares.
This is a concept that falls into the more is better category. The higher the return on equity the more attractive a company is to investors. It is known that Warren Buffett likes high ROE companies. The reason to favor high ROE companies is that ROE can be used as rough measure of management efficiency. If management is able to consistently reinvest shareholder equity at high rates it leads to growth. And to most investors Growth is god.
ROE is one of those metrics that is worth looking at, but then comparing within an industry. High Return on Equity alone is not a valid reason to invest in a company. Companies with high debt or leverage, can conceiably have higher a ROE because debt is fueling the company not shareholder equity. But the additional leverage carries with it risk.
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