Return on Equity, Explained
When assessing companies, many investors will look at their “ROE” — return on equity. Here’s a quick review of what ROE is and how to interpret it.
Let’s start with the formula, as it’s a fairly simple ratio (one number divided by another); in this case, it’s “net income” to “shareholder equity.” You’ll see the numbers you need on a company’s latest income statement and balance sheet. Near the bottom of the income statement, you’ll find net income; this reflects the company’s profits after all expenses have been subtracted from its revenue (found on the top line). To calculate ROE, you’ll need total net income over the past four quarters.
Meanwhile, on the balance sheet, you’ll find shareholder equity, the result of subtracting total liabilities from total assets. For an approximation of the equity throughout the year, average the latest shareholder equity amount and the amount a year earlier.
Now divide net income by shareholder equity, and presto — you have return on equity. For example, Walmart’s trailing 12 months of net income is $10.05 billion, and its recent average shareholder equity was $84.16 billion. Divide $10.05 by $84.16 and you’ll arrive at an ROE of nearly 0.12, or 12%.
Remember that shareholder equity is what’s left over after all liabilities (like debt) are subtracted from the company’s total assets — it’s what shareholders have a claim to. Meanwhile, net income reflects the total profits over a period. So the ROE is showing how much profit — almost $0.12 — is earned from each dollar of shareholder equity over a year. The higher the ROE, the better.
Let’s check out Costco next. Its trailing 12 months of net income was recently $4.73 billion, and its average shareholder equity $17.84 billion. Divide the first number by the second, and you get an ROE of nearly 28%. That’s more than twice Walmart’s ROE, suggesting that Costco is more productive.
A warning, though: If a company is heavily laden with debt (lowering shareholder equity), that can skew ROE upward. Never base investment decisions on ROE alone, or any other single measure.