Return on equity divides earnings by book value — the value of assets without corresponding liabilities — to see how effective management is at putting investors’ capital to work to produce value for shareholders. Investors use ROE as a valuation tool to assess the value of stock because ROE generates a useful snapshot of a company’s management, but it should not be used as a sole valuation instrument.
Most of a company’s assets on its balance sheet have corresponding liabilities. Any assets without liabilities are assumed to come from investors’ capital, as investors inject cash into a business without requiring anything in return. Thus extra assets are called shareholder equity or book value. While investors provide cash, using that cash responsibly and efficiently depends on the company’s management.
One advantage of ROE is that the measurement allows investors to look past earnings and see how effective a company is at generating benefits for its shareholders. Examining revenue and income gives investors an idea of how profitable a company is, and profits are the most important piece of information for stock prices, according to CNN Money. However, ROE provides a tool for investors to assess how a company’s revenues impact shareholders.
According to the financial advice service The Motley Fool, ROE allows investors to assess management, as the components that go into ROE include asset management, leverage and pricing. Efficient asset management causes ROE to increase via using up fewer assets, as does a high profit margin, which is reflected in earnings. Leverage — the ability to take on debt — also boosts ROE when used in moderate amounts.
ROE focuses on a company’s ability to return money to shareholders and can be compared across industries. Earnings and profit margins vary dramatically across sectors and can be difficult to compare. However, ROE takes earnings data and turns it into a very relevant measurement that can be compared across sectors.