Return on equity (ROE) is a closely-watched number among knowledgeable investors. It is a strong measure of how well a company's management creates value for its shareholders. The number can be misleading, however, as it is vulnerable to measures that increase its value while also making the stock more risky. Without a way of breaking down ROE components, investors could be duped into believing a company is a good investment when it's not. Read on to learn how to use DuPont analysis to break apart ROE and gain a much better understanding about where movements in ROE are coming from.
The beauty of ROE is that it is an important measure that only requires two numbers to compute: net income and shareholders' equity.
ROE = net income / shareholder's equity
If this number goes up, it is generally a good sign for the company as it is showing that the rate of return on the shareholders' equity is rising. The problem is that this number can also rise simply when the company takes on more debt, thereby decreasing shareholder equity. This would increase the company's leverage, which could be a good thing, but it will also make the stock more risky.