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When a publicly traded company has a high return on equity it is an indication that the management team is using resources well. In some cases, the condition of a return on equity expressed as a percentage can be clear. It is also helpful, however, to view this indicator relative to the results at other businesses in a similar sector. When investors have decided that a business does, in fact, have a high return on equity, they are more likely to buy the stock. Buying activity creates greater value for all shareholders and increases the market value of the company.
Investors who buy shares of stock in a company typically want to know that top executives are making decisions with profits that will benefit the organization and its shareholders. One way to make this determination is to measure the company's return on equity. The higher the result, the more profits the company has earned using the capital provided by investors.
To obtain a return on equity result, an investor should perform a basic calculation. The equation takes the average net income results, which may also be expressed as earnings, from the previous four quarters. That result is divided by the average value of shareholder's equity. This amount is expressed on a company's financial statement known as a balance sheet.
Obtaining this figure also requires a calculation. It is the value of assets after liabilities, or debts, have been subtracted. Return on equity is the average net income divided by the value of shareholder's equity.
Being able to calculate a return on equity gives investors useful tools for evaluating potential stock investments. When a company appears to have a high return on equity, especially in comparison with other businesses that trade in a similar industry, the stock becomes even more attractive. Subsequently, the share price is likely to rise higher, which leads to greater profits for stockholders and more resources for the business. Even with an expensive share price, investors are often willing to buy the stock of a company with a high return on equity because this represents a company where value is being created.
A high return on equity also means that a business is financing its operations wisely, and not obtaining an excessive amount of debt in order to grow. This is beneficial for the overall financial health of the entity. With greater control over the profits generated by the business, management teams can decide to reward investors with dividend payments or use the money to reinvest in the company for more growth.