Computing for the return on equity or ROE is so simple and easy. Even you will not believe that something as simple as this is highly important when making investment decisions. The ROE determines how well a company works and if it gets any returns for the clients. Although simple and easy, getting the accurate ROE can be difficult because obtaining and using the data should be accurate, too.
Understanding the Formula
Calculating mathematical problems is always easier with formula. Even getting the ROE has a formula also. To get the ROE, the net income is divided by the shareholder equity. Here is a mathematical equation for that:
ROE = Net Income / Shareholder Equity
The net income is the company's pure income. Tax and liabilities are already subtracted from the figure to come up with the net income. Meanwhile, the shareholder equity is the difference between the total assets and the total liabilities.
Many people, who are not familiar with finance accounting, question the credibility of this formula. They say that the formula should include the so-called three pillars of a corporate management-profitability, financial leverage, and asset management. Actually, these three important pillars are in the original formula. Using the DuPont formula, you will see these three pillars.
ROE = Net Income x Sales __ x Total Assets _
Sales Total Assets Stockholder Equity
If this formula is simplified, you will still end up using the first formula. Since there are "Sales" and "Total Assets" both in the denominator and numerator, these variables will be crossed out. And so, only "Net Income" and the "Stockholder Equity" will be left on the formula.
Computing the ROE Accurately
The formula is important to get the accurate ROE. But actually, the accuracy of the computation relies on the accuracy of the data. That is why you should be really careful when obtaining your data. For example, if you want to get the entire ROE of the company for this year, then use only the data for this year. If you want to know the ROE for the last 10 years, then get the average of net income and shareholder equity for the last 10 years and use those figures.
These additional computation jobs are simpler than obtaining the real and accurate data. Don't just rely on the company to give you the data. Instead, research on yourself to obtain your needed figures.
There are some companies that change the shareholder equity or the net income so that the total ROE will be higher than what it really is. Financial experts advise investors to get data from the most reputable sources like the Securities and Exchange Commission. The balance sheet can also be used to get the more accurate shareholder equity.
Assessing the Figure
You have obtained the most accurate data you can get and have done with the computation. Now, what does the figure means? The total figure determines the ROE. What does the ROE mean?
The ROE ans how much profit is earned with the available assets. For example, if the ROE is 10%, then, the company is earning $10 for every $100 of investment.
Compare the ROE also on the present status of the economy. Usually, figures 10% to 15% are considered good. Lower than this is okay but not that outstanding. Higher figures than 15% are surely more competitive.
As long as the ROE is computed correctly using the most accurate data, you surely can get the most accurate assessment about the company. The figure is not just a figure, but also an important data that will guide you into making the right decision.