Investing, some people will tell you, is just a crap shoot -- more luck than skill. But you can use financial measures to educate yourself about your investments and increase your odds of being successful. Return on equity is the ratio of a company's returns to the money put in by investors. As a financial measure, it offers a number of benefits to investors who want insight into a company.
It's always good to know how your investments stack up against their peers. Return on equity can benefit you as an investor because it allows you to benchmark the performance of companies against each other. Different industries have different equity requirements because some require large capital investments, while others require minimal cash injections before turning a profit. To get an accurate comparison for a company, look at others in the same industry. For example, you might compare the return on equity of ExxonMobil to another oil company such as Chevron.
Sometimes it's good to keep it simple, and other times you want the dirty details; return on equity can be measured in both ways. This allows you to perform a quick, simple analysis of a stock that you have a fleeting interest in or go into greater detail for a major investment. The simplest measure for return on equity is to divide net income by average total equity. The so-called DuPont method breaks these elements down into components including asset turnover and and profit margin, allowing for more detailed analysis.
When you invest in stocks, you're trusting your money to strangers -- but how do you know they're competent? You can't drop in to visit the CEO of a company that you've invested in, but according to the authors of "Principles of Accounting," return on equity can be used to gauge the performance of a company's managers. A higher return on equity indicates that the managers are more efficient at creating profits from your investment.
You want to make sure that your investment is more than just a flash in the pan. Return on equity can be beneficial when used in a trend analysis. A trend analysis of return on equity involves plotting a company's return on equity over the years. This will show you if it is growing or slowing -- or if it is at all consistent. This way you can avoid stocks that have declining or inconsistent return on equity.
- Investment Analysis and Portfolio Management; Frank K. Reilly and Keith C. Brown
- Principles of Accounting; Belverd E. Needles, Marian Powers et al.
- Financial Management Theory and Practice; Eugene F. Brigham and Michael C. Ehrhardt