Return on equity
Return on equity (ROE) is a
measure of how well a company used reinvested earnings to generate
additional earnings. It is viewed as one of the most important financial
ratios. It measures a firm's efficiency at generating profits from every
dollar of shareholders' equity , and shows how much profit a company
earned in comparison to the total amount of shareholder equity found on
the balance sheet. ROE is equal to a fiscal year's net income (after
preferred stock dividends but before common stock dividends) divided by
total equity (excluding preferred shares), expressed as a percentage.
ROE is calculated as:
ROE=Net income/Sharesholder's equity
Net income is for the full fiscal year (before dividends paid to common
stock holders but after dividends to preferred stock.) Shareholder's
equity does not include preferred shares.
There are several variations on the formula that investors may use:
1. Investors wishing to see the return on common equity may modify the
formula above by subtracting preferred dividends from net income and
subtracting preferred equity from shareholders' equity, giving the
return on common equity (ROCE) = net income -
preferred dividends / common equity.
2. Return on equity may also be calculated by dividing net income by
average shareholders' equity. Average shareholders' equity is calculated
by adding the shareholders' equity at the beginning of a period to the
shareholders' equity at period's end and dividing the result by two.
3. Investors may also calculate the change in ROE for a period by first
using the shareholders' equity figure from the beginning of a period as a
denominator to determine the beginning ROE. Then, the end-of-period
shareholders' equity can be used as the denominator to determine the
ending ROE. Calculating both beginning and ending ROEs allows an investor
to determine the change in profitability over the period.
Return on equity is particularly important because it can help you cut
through the garbage spieled out by most CEO’s in their annual reports
about, “achieving record earnings”. Warren Buffett pointed out years ago
that achieving higher earnings each year is an easy task. Why? Each year,
a successful company generates profits. If management did nothing more
than retain those earnings and stick them a simple passbook savings
account yielding 4% annually, they would be able to report “record
earnings” because of the interest they earned. Were the shareholders
better off? Not at all; they would have enjoyed heftier returns had the
earnings been paid out. This makes obvious that investors cannot look at
rising per-share earnings each year as a sign of success. The return on
equity figure takes into account the retained earnings from previous
years, and tells investors how effectively their capital is being
reinvested. Thus, it serves as a far better gauge of management’s fiscal
adeptness than the annual earnings per share.
Investors usually look for companies with returns on equity that are high
and growing.A business that has a high return on equity is more likely to
be one that is capable of generating cash internally. For the most part,
the higher a company’s return on equity compared to its industry, the
better. This should be obvious to even the less-than-astute investor If
you owned a business that had a net worth [shareholder’s equity] of $100
million dollars and it made $5 million in profit, it would be earning 5%
on your equity [$5 / $100 = .05, or 5%]. The higher you can get the
“return” on your equity, in this case 5%, the better.
But not all high-ROE companies make good investments. Some industries have
high ROE because they require no assets, such as consulting firms. Other
industries require large infrastructure builds before they generate a
penny of profit, such as oil refiners. You cannot conclude that consulting
firms are better investments than refiners just because of their ROE.
Generally, capital-intensive businesses have high barriers toentry, which
limit competition. But high-ROE firms with small asset bases have lower
barriers to entry. Thus, such firms face more business risk because
competitors can replicate their success without having to obtain much
outside funding. As with many financial ratios, ROE is best used to
compare companies in the same industry.
High ROE yields no immediate benefit. Since stock prices are most strongly
determined by earnings per share (EPS), you will be paying twice as much
(in Price/Book terms) for a 20% ROE company as for a 10% ROE company. The
benefit comes from the earnings reinvested in the company at a high ROE
rate, which in turn gives the company a high growth rate. ROE is
presumably irrelevant if the earnings are not reinvested.
The sustainable growth model shows us that when firms pay dividends,
earnings growth lowers. If the dividend payout is 20%, the growth expected
will be only 80% of the ROE rate. The growth rate will be lower if the
earnings are used to buy back shares. If the shares are bought at a
multiple of book value (say 3 times book), the incremental earnings
returns will be only 'that fraction' of ROE (ROE/3).
New investments may not be as profitable as the existing business. Ask
"what is the company doing with its earnings?" Remember that ROE is
calculated from the company's perspective, on the company as a whole.
Since much financial manipulation is accomplished with new share issues
and buyback, always recalculate on a 'per share' basis, i.e. earnings per
share/book value per share.
ROE encompasses the three pillars of corporate management --
profitability, asset management, and financial leverage. By seeing how
well the executive team balances these components, investors can not only
get an excellent sense of whether they will receive a decent return on
equity but can also assess management's ability to get the job done.The
DuPont formula, also known as the strategic profit model, is a common way
to break down ROE into three important components. Essentially, ROE will
equal net margin multiplied by asset turnover multiplied by financial
ROE=(Net income/Sales) * (Sales/total
assets)*(Total assets/average stockholders equity)
Splitting return on equity into three parts makes it easier to understand
changes in ROE over time. For example, if the net margin increases, every
sale brings in more money, resulting in a higher overall ROE. Similarly,
if the asset turnover increases, the firm generates more sales for every
dollar of assets owned, again resulting in a higher overall ROE. Finally,
increasing financial leverage means that the firm uses more debt financing
relative to equity financing. Interest payments to creditors are tax
deductible, but dividend payments to shareholders are not. Thus, a higher
proportion of debt in the firm's capital structure leads to higher ROE.
Financial leverage benefits diminish as the risk of defaulting on interest
payments increases. So if the firm takes on too much debt, the cost of
debt rises as creditors demand a higher risk premium, and ROE decreases.
Return on assets is one of the elements used in financial analysis using
the Du Pont Identity. and be impacted by inventory directly. Increased
debt will make a positive contribution to a firm's ROE only if the firms
ROA exceeds the interest rate on the debt.