When evaluating dividend paying stocks a key factor is return on equity or ROE.  It’s a measure of how efficiently a company is using the capital it has to grow profits which, in turn, grow dividend payments.

Stock markets exist to facilitate the exchange of capital.  Investors have capital that they’re looking to earn a return on and corporations need capital to operate and grow.  Equity investments like stocks allow investors to exchange some of their capital for a small equity stake in a corporation and they expect that equity stake to produce profits for them.

But all profits are not the same.  Profits from sales are different than profits from equity.  A company might earn 10% profit margin on 200 million dollars in sales but all that tells us is that it’s been a good year.  Sales can ebb and flow and are, at best, a short term indicator of company health.  A long and growing history of sales builds a different kind of return – return on equity.

Equity is the amount shareholders have invested in a corporation and return on equity is profits compared to that equity.  A high return on equity means that a company earns a lot for every dollar invested while a low return on equity means they earn little.  A high return on equity means efficiency and a business whose growth is cheaper to fund while a low return on equity tends to mean slower growth because each dollar invested adds to the bottom line less efficiently.

Here’s a quick example that will make this relationship clear.

Suppose Company A is our corporation that has 200 million dollars in sales with a 10% profit margin for total yearly revenue of $20 million.  Company B has much larger sales of $2 billion but only a 1% profit margin for a yearly revenue that’s also $20 million.

On the surface, Company A looks like the better company.  It’s making the same profit off of less revenue and has ten times the profits per share of stock.

But what if Company A shows $500 million in shareholder equity while Company B shows $100 million?  Return on equity (ROE) is $20 million / $500 million or 4% ROE while Company B has $20 million / $100 million or 20% ROE.

It’s clear that Company B, even though it has a 1% profit margin, uses the equity investors have provided in much more efficiently than Company A.  For each dollar of shareholder equity, A returns 4% while B returns 20%.  Company A may have ten times more sales but company B is five times more efficient with its equity making it much easier for B to use equity to grow profits than A.

You don’t have to understand all these numbers to understand the core concept here – corporations that have high return on equity provide more value to shareholders for every dollar invested than corporations that have low return on equity.  Regardless of short term profits that may spike profit margin and short term share price growth, ROE is the metric that drives a long term and sustainable business.

And, for our purposes, return on equity also drives long term and sustainable dividend payments as well.