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The fool School
Return on equity
When evaluating a company to see whether it belongs in your portfolio, you should calculate its return on equity (ROE). The ROE reflects the productivity of the net assets (assets minus liabilities) that a company's management has at its disposal.
Whenever a company generates earnings, there are four main things it can do with that profit. It can pay shareholders a dividend, pay down its debt, buy back shares of its company stock, or reinvest in operations.
Return on equity reveals how effectively reinvested earnings (and capital that shareholders originally invested in the company) are used to generate additional earnings. For example, profits might be used to acquire another company. Or a new factory might be built, upping the firm's output and sales.
To calculate return on equity, take one year's (or four quarters') worth of earnings (often referred to as "net income") from the income statement. Next, look at shareholders' equity on the balance sheet. Average the shareholders' equity by adding the figures from the beginning and end of the year and dividing by two. Now divide the year's earnings by the average shareholders' equity. (Whew!)
Consider Johnson & Johnson. In its last reported fiscal year (1999), it reported net income of $4.2 billion and average shareholder equity of $15.1 billion. Dividing 4.2 by 15.1 yields a return on equity of about 28 percent. That's an impressive number, but it's even more meaningful when compared to the company's past performance. The company's ROE for 1998 was about 23 percent, down significantly from 1997's 28 percent. Executives at this pharmaceutical and consumer-product enterprise seem to be getting back on track, improving the use of shareholders' capital.
Another way to add context is to compare a company with its peers. Here are recent ROE figures for some of J&J's peers: Merck (45 percent), Procter & Gamble (29 percent), Pfizer (36 percent). This is clearly an industry with robust performance, and J&J appears to have some room for improvement.
When crunching any numbers for a company, it's valuable to compare them with previous quarters or years, and with those of industry peers. And when evaluating management effectiveness, return on equity can be very telling.
Last January I bought 15 shares of Jenny Craig stock at $3.55 a share after hearing that Monica Lewinsky would be its spokesperson. I thought the price would go through the roof. Boy, was I wrong! I've watched the price drop to $2 and lower. I'm hanging on for awhile longer, as it cost me $50 to buy the stock and it'll cost me $50 to sell it. The only smart thing I did was buying just 15 shares. Ann Rebuffattee, Coronado, Calif.
The Fool Responds: Ouch. Remember that stocks selling for less than $5 are penny stocks and tend to be extra risky. Also, paying $50 to buy $53.25 of stock means the shares would have had to almost double in value just for you to break even and to triple to cover your selling cost. (Discount brokers often charge less than $10 per trade. Learn more about them at http://broker.fool.com.) Finally, don't hang on to a losing stock if you no longer believe in the company. At least these lessons didn't cost you too much.