Return on Equity Calculation and Drawbacks

Having a given amount of resources different management teams may achieve different results. It all depends on how efficiently they will use the available resources.

A measurement for evaluating the efficient use of resources by a company in producing earnings for its shareholders is the Return on Equity (ROE).

Return on Equity Calculation

In order to calculate the ROE use the following formula:

ROE = Net Income / Book Value

A good ROE ranges between 13% and 15%. The ROE can be used to make comparisons between companies from one and the same industry.

Return on Equity (ROE) Drawbacks

Despite its convenience and benefits, ROE has its disadvantages you should be well aware of. One of them is that the ROE can be artificially inflated. This is done trough the division of a smaller book value. The latter can be caused by the borrowing of funds, instead of issuing stocks.

Book value can be also reduced through the taking of write downs, stock buy backs and etc. As a result the ROE is increased and at the same time the profits are not improved.

Many financial experts recommend the examination of ROE over a longer period of time, not just the study of the past year Return on Equity. This will eliminate any abnormal numbers out of the picture and will give a more realistic view.

Many investors successfully apply ROE as a tool for finding competitively advantageous companies. Over the long run, companies that are good at generating higher profits with the assets they have available represent a more viable and beneficial in financial terms investment.

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For knowledge we can highly recommend you subscribe to the The Wall Street Journal.

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