(I originally posted this article on The DIV-Net website on October 5, 2008)
Return on equity provides information on how well management has invested the capital supplied by its shareholders. ROE is calculated by dividend earnings per share by book value per share than multiplying by 100 to convert to a percentage. In a recent article in BetterInvesting Magazine, it is noted adjustments may need to be made to equity to get an accurate measure of book value.
A company’s book value is determined by subtracting long- and short-term debt from the company’s total assets. It represents what a shareholder would get if the company and its assets were sold at cost. A note of caution about book values: If you’re dealing with a company that has most of its assets related to intellectual property or brands, the figure might be more art than science. The book value of drug patents, factory equipment and vehicle fleets are easily quantified. The book value of a brand isn’t so firm (though it would be foolish to say that brands such as Coca-Cola and McDonald’s don’t have value).
In general, a higher ROE means the company is generating capital with its existing assets. This ability to generate capital internally means the company is less likely to issue more equity (dilutive) or take on more debt. The additional capital that is generated can then be used for business expansion, stock buybacks and/or dividend increases.
Additionally, I published a post on The DIV-Net website today that covers another management evaluation tool: reviewing the shareholder letter. In addition to the detail on the shareholder letter review, the post contains some advice from Warren Buffett on potential expectations for the coming weeks ahead.
Measuring Management by Return on Equity ($)
By: Michael Maiello