So what is Return on Equity (ROE) and why do we care about it? Good question!
This valuable statistic tells you how efficient a company is at using the money invested from shareholders to generate profits.
A high ROE means that a company has been successful in using shareholder’s equity to invest in growth projects that yield high returns. Also, it allows a company to invest less money to hit growth targets than it would have to if its ROE was lower. This is because the returns are higher.
A low Return on Common Equity means growth is expensive to finance and we dividend investor’s don’t like that!! A high ROE signals a profitable company.
Here’s how to calculate it...
ROE = NET INCOME (OR PROFIT)/SHAREHOLDER’S EQUITY (OR NET WORTH)
Now let’s run through an example to clear things up...
Say XYZ Financial posted a net income of $40 Billion Dollars last year and their average shareholder’s equity was $160 Billion.
Using the formula above... $40 Billion/$160 Billion = 0.25 or 25% ROE
So XYZ accomplished a 25% return on the equity their shareholder’s had invested in the company. Not bad at all!!
So why is ROE important to you as a dividend growth investor?
The profit that’s left after paying out dividends to shareholders is used to invest for future growth. So if a company can get a higher return on the money it invests than it doesn’t have to use as much.
This leaves the company with excess cash. It can now do other things like repurchase its shares or pay out special dividends!
On the flip side, if the corporation has a lower Return on Equity Ratio then it has to invest more money to hit growth targets. So a greater percentage of the money that’s left after paying out dividends will be required.
A less profitable company has fewer options and less flexibility and we don’t like that!
You will learn later on what to look for in terms of ROE from a dividend growth stock.