The Motley Fool: Pay attention to return on equity

When studying a company to see if it has the makings of a fine investment, a useful number to calculate (or look up) is its return on equity (ROE). The ROE reflects the productivity of the net assets (assets minus liabilities) a company’s management has at its disposal.

Whenever a company generates profits, there are four main things it can do with that moolah. It can pay shareholders a dividend, pay down debt, buy back shares of the 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.

You can look up ROEs online, such as at http://finance.yahoo.com (look for “Key Statistics”), but it’s good to know how the math is done. 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 2. Now divide the year’s earnings by the average shareholders’ equity. (Whew!)

Consider Kellogg’s. In fiscal 2006, it reported net income of $1 billion and average shareholder equity of $2.2 billion. Dividing 1 by 2.2 yields a return on equity of around 45 percent. That’s impressive, but it’s even more meaningful when compared to past performance. Kellogg’s ROE was around 53 percent in 1998 and 69 percent in 2000, and its average over the past decade has been 54 percent. So it’s not operating at its highest levels recently.

Another way to add context is to compare a company with its peers. Morning- star.com’s stock screen offers the following ROEs: Kraft Foods, 11 percent; Heinz, 35 percent; General Mills, 20 percent; and Campbell’s Soup, 54 percent. Whenever you crunch any company numbers, it’s valuable to compare them with previous quarters or years and with those of competitors.

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My dumbest investment

My dumbest investment was passing on Google when it was trading below $100 per share because I could afford only 10 shares. — F.T.B., via e-mail

The Fool Responds: This is a common mistake, thinking you have to buy many shares of a company in order to make serious money. Another error is assuming that you can’t buy fewer than 100 shares.