Analysts use a variety of analytical tools to evaluate a company's profitability. One of most commonly used tools is the return on equity calculation. Return on equity is calculated by dividing the company's net profit by shareholder equity. Higher or rising returns on equity are better than decreasing returns on equity, because it means that a greater percentage of a company's profits are returned to investors. One way to predict a company's future profitability is to analyze its historical return on equity calculations.
1. Calculate the most recent financial year's return on equity. To calculate return on equity, divide the company's year end net profit on the income statement by the shareholder's equity total that's on the balance sheet. Sometimes, companies report shareholder equity on a separate shareholder equity statement.
2. Repeat the return on equity calculations for each year of data you have. Two years is barely adequate, but it may give you an idea of where the company is headed in the near term -- especially if the company is young. A three-to-five year history is better.
3. Compare the return on equity calculation results. Are they rising over time, stagnating or falling? Rising returns are better, because it usually indicates that the company is using its resources wisely while also increasing income. Stagnating or falling returns may mean a lack of growth.
- A company that has a large amount of debt on its balance sheet may show a high return on equity, because shareholder's equity equals assets minus liabilities. Therefore, be sure to examine not only the return on equity figures, but also the amount of debt that the company has. If debt has increased substantially over the analysis period, then the return on equity calculation may not present an accurate picture of the company's health.
Items you will need
- Annual income statements
- Year end balance sheets
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