The Motley Fool: Take closer look at 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 recommendation 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.

Ask the Fool

Q: What does rebalancing a portfolio mean? — H.C., Anderson, Ind.

A: It involves tweaking the percentage of your portfolio in various holdings (such as stocks, bonds, etc.) by reallocating your money. Imagine that three years ago you invested in 10 companies, putting about 10 percent of your portfolio’s value in each. If today one of the firms has grown to represent 30 percent of your portfolio, you might rebalance by selling off some of that and reinvesting the money elsewhere.

Rebalancing isn’t always best. Sometimes it’s good to let your winners keep winning, as long as they still seem undervalued, with ample room to grow.

My dumbest investment

My dumbest mistake was selling four Class B shares of Warren Buffett’s Berkshire Hathaway company at $2,800. They’ve been above $4,000 recently. I seem to sell either too soon or not soon enough. But in the long run, I am still ahead. — Zemina, online

The Fool Responds: Bad timing is a common investor mistake. We often sell too soon, either due to panicking at a temporary downturn, or because we’re not patient enough to wait for a stock to reach its true value. Often, we hang on too long, despite having lost confidence in the company’s management and future. Sometimes we sell prematurely because a new (to us) and exciting stock has captured our imagination. You’re right to look at the long run, though, because it’s what really counts. As long as you’re beating the market over many years, you’re doing all right. If you’re not, then consider investing in a simple broad-market mutual fund, such as one based on the S&P 500. It will let you roughly match the market’s performance — which is enough to outperform most managed mutual funds.