Return on equity (ROE) is considered as a measure of how effectively management is using investor capital to create profit. As well as to generate earnings growth. Simply put, the ROE ratio shows how much income each dollar of common stockholders equity generates. Thus making it important to you.
As simple as it is to calculate, return on equity is fundamentally important to your research and trading decisions. That is, as long as it is properly understood.
Investing in companies that generate profits more efficiently than their rivals can be very profitable. Return on equity (ROE) can help you distinguish between companies that efficiently create profits and those that don’t.
On the other hand, ROE might not necessarily tell the whole story about a company and must be used carefully.
On the surface ROE is a profitability measure. But within its core, it encompasses not only profitability but also asset management and financial leverage.
Due to this, you can get a good sense of whether you will receive a decent return on your investment. As well as assess the current company leader’s ability to manage the business effectively.
Return on Equity Calculation
ROE is expressed as a percentage and is generally only calculated for companies with positive net income and equity.
To calculate return on equity, you take net income for the year and divide it by the average shareholder equity for that year:
A company has an annual net income of $500,000 and average shareholders equity of $2,500,000.
This company’s ROE is 20% –
Net income is the amount of income, net of expenses, and taxes that a company generated for a given period. With the income for the trailing twelve months often being used for the ROE formula.
Most of the time, ROE is computed for common stockholders. Thus, preferred dividends are taken out of the net income as these profits are not available to the common stockholders.
Average shareholders equity comes from the balance sheet. It is considered best to calculate ROE based on the average equity of the period. As this better matches the equity to the changes in income.
Importance of ROE
ROE provides a simple metric for evaluating returns. Of particular importance to you is that ROE provides a view of profitability from your point of view. Not the company’s. In other words, this ratio calculates how much money is made based on your investment in the company.
A high return on equity is also generally a strong indicator of a company’s ability to pay you back in dividends. A company won’t always do so of course. As it may be more beneficial to reinvest and capitalize on its growth.
In this case your value increases from the future growth in earnings as opposed to receiving a dividend. Which you would then have to find another place to invest.
By comparing a company’s ROE to the industry average, you can observe differences in management performance. As well as differences in their growth and returns.
You want to see a high return on equity ratio because this indicates that the company is using your funds effectively. Companies that have a higher ROE than peers typically have a competitive advantage. Which often translates into higher returns for you.
A sustainable and increasing ROE can mean that management is creating value. As a result, giving you more for your money.
In contrast, a declining ROE can mean that management is making poor decisions when reinvesting your capital.
Using and Interpreting Return on Equity
ROE is best used as a comparison to other companies in the industry, since every industry has different operating norms. When used to evaluate one similar company to another, the comparison will be more meaningful.
For example, if you look at an auto stock and a semiconductor equipment stock. When compared to each other the ROE ratios won’t tell you much.
The auto stock has an ROE of 9% while the semi stock’s ROE is 20%. If the auto and truck industry average ROE is 7%. While the semiconductor equipment industry average is 26%. The auto stock is actually performing better related to peers than the semi stock.
The relative value of return on equity (ROE) will depend on what’s normal for a stock’s peers. A good rule of thumb is equal to or just above the industry average.
Consider Facebook (FB) with an ROE of 23.7% as shown on finviz
Compared to its peers, Facebook (FB) has a strong ROE:
- Twitter (TWTR) – 20.6%
- Alphabet/ Google – 16.2%
- Baidu (BIDU) – 12.9%
It is also very useful to compare the average over the past five years to get a view of which way the returns are moving. And how the dynamics of the company may be changing.
The DuPont Formula – Deeper Insight
DuPont chemical came up with a more insightful way of looking at return on equity. With this formula you can get a more detailed view of the metrics behind ROE. Lending to a view of profitability, asset usage, and financial leverage all in one.
The DuPont formula calculates return on equity as the net profit margin multiplied by asset turnover multiplied by financial leverage.
It will generate about the same result as the classic ROE formula. However, it will help you break down a company’s performance more clearly.
Splitting return on equity into three parts makes it easier to understand the causes of change in ROE over time.
- Net profit margin increases – sales turn into higher income – resulting in a higher overall ROE
- Asset turnover increases – the company sales increase for every unit of assets owned – resulting in a higher overall ROE
- Financial leverage increases – the firm uses more debt financing related to equity financing – resulting in lower equity and therefore a higher ROE
Instead of just seeing the change in ROE, you can see why it changed. Letting you better assess the good and bad.
Using ROE to Identify Problems
Sometimes an extremely high ROE is a good thing if net income is high compared to equity due to strong performance. However it may not always be a good thing. A relatively high ROE could also be a sign of excessive debt or inconsistent profits.
A high ROE doesn’t tell you if a company has excessive debt. A higher proportion of debt in the company’s capital structure leads to a higher ROE. As with more debt there is less equity.
ROE Example with Debt
Look at two companies with the same amount of assets ($1,000,000) and the same net income ($150,000) but different levels of debt:
- ABC has $500,000 in debt and therefore $500,000 in shareholders equity ($1,000,000 – $500,000)
- XYZ has $100,000 in debt with $900,000 in shareholders equity ($1,000,000 – $100,000)
- ABC shows a ROE of 30% ($150,000/ $500,000)
- XYZ shows a ROE of 16.7% ($150,000/ $900,000)
As ROE equals net income divided by the shareholders equity. ABC shows the highest return on equity.
ABC looks as though it has higher profitability to its equity when really it just has more debt obligations. Its higher ROE may therefore simply be a mask of future problems.
It’s important to keep in mind that not all debt is bad. And if it is managed well, it can be positive to the underlying growth of ROE.
This is why the DuPont formula is more insightful. As it gives you more clarity as to what is affecting the return on equity (ROE).
Another potential issue with a high ROE is when a company has inconsistent profits.
You are looking at a company that has been unprofitable for many years. The losses over the years reduce shareholders equity.
If the company all of sudden swings to profitability one year. The shareholder equity value is low due to all of the losses. Making the ROE misleadingly high.
Negative and extremely high ROE numbers are not always bad. But in all cases, they should be considered a sign worth investigating. At the same time, a company with a negative ROE should not be compared to others that have positive ROE ratios.
Return on equity measures how effectively management is using your capital to create income.
Whether the ROE is good or bad will depend on what’s normal for the industry and company peers.
A high return on equity (ROE) can signal a company has a competitive advantage. At the same time, be aware of its shortfalls with the potential to mask debt or inconsistent profits.
Taking it a step further, the DuPont formula is designed to help you assess many of these issues. And you can also use a 5 year track record to help find companies with stable and growing returns.
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