Return on Equity

When a company generates earnings, there are many things it can do with that profit. For example, it can pay shareholders a dividend, pay down its debt, buy back shares of its company stock, or reinvest in operations. Return on equity (ROE) 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 to build a new factory. To determine how productive a company is with its net assets (assets minus liabilities), you can calculate its ROE.

To calculate ROE, 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 Motley Fool Stock Advisor rec- ommendation Costco (Nasdaq: COST), America's largest wholesale club operator. In fiscal 2007, it reported net income of $1.1 billion and average shareholder equity of $8.9 billion. Dividing 1.1 by 8.9 yields a return on equity of around 12 percent, a solid number. It's instructive to look at previous numbers, too. Costco's ROE has been in the 12 percent range for several years now, reflecting stability.

Another way to add context is to compare a company with its peers. Costco's main competitor is Wal-Mart, with its chain of Sam's Club warehouses. Wal-Mart's ROE has recently been in the neighborhood of 20 percent, an impressive number.

When evaluating companies in which to possibly invest, be sure to do deep research and to crunch more numbers than just the return on equity. Examine factors such as profit margins, growth rates and competitive advantages. High debt can skew ROE upward, so check to see whether the firm has a lot of debt, too.

Learn more about how to evaluate investments via the "Investing Education" box at www.fool.com/investing.htm.