Within the realm of fundamental analysis, investors are expected to delve into financial statements for the purposes of developing investment strategies. Among the numerous strategies that can be derived from financial reports, calculating return on equity can help investors make educated decisions about the efficiency of company directors and managers with regard to the equity they have acquired through shareholders.
Equity has different meanings for company executives and investors. Accountants look at equity in terms of assets minus liabilities; in this sense, equity is essentially value. The opposite of equity is deficit, and operating funds that are greater than equity are considered to be surplus. Shareholders’ equity is considered to be capital since it is fractionally divided among investors.
The economic prospects of a company can be determined by the equity held by shareholders, this is particularly the case with publicly traded companies listed on major stock exchanges. When shareholders accumulate shares, they are essentially increasing the equity of the company even though they are not exactly giving up their money. To a great extent, shareholders’ equity is similar to a prestigious line of credit; a company can negotiate financing agreements without having to risk collateral because the equity speaks for itself. In other words, shareholders’ equity can determine growth, but it is ultimately up to management teams to take advantage of this financial prospect.
Return on equity is a ratio similar to return on investment. The goal is to determine how well the company is managing the economic opportunity provided by shareholders. Once a company files an initial public offering and lists its stock on a major exchange, the management team is expected to put this capital to work in order to generate income, profits and growth, which in the end provides increased value to shareholders.
Two formulas can be used to calculate return on equity:
* Net Income or Unencumbered Cash Flow divided by Shareholders’ Equity
* Growth Rate of Dividends divided by Earnings Retention
The first formula is more fundamental than the second since its values can be obtained from financial reports such as income statements and balance sheets. The second formula is little more technical since its values are obtained from market analysis reports.
ROE ratios must be compared within industries and peers; for example, if an analytical report estimates that the average ROE for the American banking industry is 5.25 percent, a national bank with an ROE of 6.50 percent suggests that its management team is performing well in terms of putting shareholder’s equity to work.
The performance of management teams is of great importance for value investors who wish to take strong and long-term market positions; to this effect, ROE can be calculated on a quarterly basis to track how well the management team is doing against competitors and peers.
It should be noted that ROE is not impervious to other factors such as overall market sentiment and the herd instinct. In the first quarter of 2018, for example, shares of many companies exceeded their ROE because of the bullish sentiment that has prevailed on Wall Street since 2015.