Return on Equity (ROE)

Evaluates the returns on a company compared to the size of its equity

What is Return on Equity?

Return on Equity (ROE) is a measure of a company’s profitability. It is a two part ratio that brings together the income statement and the balance sheet, because the net income or profit is compared to the shareholders’ equity. The number represents the total return for the capital employed and shows the firm’s ability to turn assets into profits. To put it another way, it is the profits made for each dollar from shareholders’ equity.  The following is the ROE’s equation:

ROE = Net Income / Shareholder’s Equity 

ROE simplifies comparison of return. By comparing it to the industry’s average, it may reveal a company’s competitive advantage. Another insight is how the management is using the financing from equity to grow the business. A sustainable and increasing ROE over time can mean a company is good at generating shareholder returns, because it knows how to reinvest its earnings in productive and high quality assets. In contrast, a declining ROE means that management is making poor decisions on investing capital in successful asset. Market price is affected by the changes in the book value (shareholders’ equity), so if ROE remains small even when the company is retaining those earnings, then market price will reflect that small change in the book value. This is not a good sign for the company.

Why use it?

With ROE, Investors can see if they’re getting a good return on their money, while a company can evaluate how efficiently they’re utilizing shareholder’s equity. ROE must be compared to the historical ROEs of the company and to the industry’s ROE average, as it would mean nothing if used in isolation. Other investments can be looked at such as the return on a bank to compare and decide if it’s worth the risk of investing in a company. A company should be able to generate a higher ROE than a return in a lower risk asset to convince investors. Just like most financial ratios, ROE must be combined with other ratios to get a better overview of a company’s financial health and performance. For instance, a low Price-to-Book ratio and a rising ROE can be a cheap buy and perhaps a good investment. Additionally, if an investor wants to delve deeper into the company’s financials, ROE is a starting point to perform a Du Pont Analysis.

Effect of Leverage:

A high ROE could mean a company is more successful in generating cash internally. However, it doesn’t fully show the risk associated with that return. A company may rely heavily on debt to generate an outstanding net profit, thereby boosting the ROE higher.

As an example, if a company has $150,000 in equity and $850,000 in debt, then the total capital employed is $1,000,000. This is the same number for total assets employed. At 5%, it will cost $42,000 to service debt, annually. If the company manages to increase its profits before interest at 12% of assets employed, the remaining profit after paying the interest is $78,000, which will increase equity by more than 50%, assuming the profit gets reinvested back. As we can see, the effect of debt is to magnify the return on equity.

Weaknesses:

The ratio can be skewed by share buybacks. When management repurchases its shares from the marketplace, this reduces the number of outstanding shares. Thus, ROE increases as the denominator shrinks. Another weakness is the ratio tells little about when the return will turn into cash and dividends. Some ROEs readily available for a company may exclude intangible assets from shareholders’ equity. Intangible assets are non-monetary items such as goodwill, trademark, copyrights and patents. This can make ROE calculations misleading and difficult to compare to other firms that have included intangible assets. Furthermore, the ratio includes some variations on its composition, and there may be some disagreements between analysts. For example, the shareholders’ equity can either be the beginning, ending or the average of the two, while Net Income can be substituted for EBITDA and EBIT, and can be adjusted or not for non-recurring items.