It pays to invest in companies that generate profits more efficiently than their rivals. Return on equity (ROE) can help investors distinguish between companies that are profit creators and those that are profit burners. On the other hand, ROE might not necessarily tell the whole story about a company, and therefore must be used carefully.
What Is ROE?
By measuring how much earnings a company can generate from assets, ROE offers a gauge of profit-generating efficiency. ROE helps investors determine whether a company is a lean, mean profit machine or an inefficient clunker. Firms that do a good job of milking profit from their operations typically have a competitive advantage - a feature that normally translates into superior returns for investors. The relationship between the company's profit and the investor's return makes ROE a particularly valuable metric to examine.
To find companies with a competitive advantage, investors can use five-year averages of the ROEs of companies within the same industry.
| Net Income
You can find net income on the income statement, but you can also take the sum of the last four quarters worth of earnings. Shareholders equity, meanwhile, is located on the balance sheet and is simply the difference between total assets and total liabilities. Shareholder equity represents the tangible assets that have been produced by the business. Both net income and shareholder equity should cover the same period of time. (To learn more, read Breaking Down The Balance Sheet.)
How Should ROE Be Interpreted?
ROE offers a useful signal of financial success since it might indicate whether the company is growing profits without pouring new equity capital into the business. A steadily increasing ROE is a hint that management is giving shareholders more for their money, which is represented by shareholders' equity. Simply put, ROE indicates know how well management is employing the investors' capital invested in the company.
It turns out, however, that a company cannot grow earnings faster than its current ROE without raising additional cash. That is, a firm that now has a 15% ROE cannot increase its earnings faster than 15% annually without borrowing funds or selling more shares. But raising funds comes at a cost: servicing additional debt cuts into net income and selling more shares shrinks earnings per share by increasing the total number of shares outstanding.
So ROE is, in effect, a speed limit on a firm's growth rate, which is why money managers rely on it to gauge growth potential. In fact, many specify 15% as their minimum acceptable ROE when evaluating investment candidates.
ROE Isn't Perfect
ROE is not an absolute indicator of investment value. After all, the ratio gets a big boost whenever the value of the shareholder equity, the denominator, goes down.
If, for instance, a company takes a large write-down, the reduction in income (ROE's numerator) occurs only in the year that the expense is charged; the write-down therefore makes a more significant dent in shareholder equity (the denominator) in the following years, causing an overall rise in the ROE without any improvement in the company's operations. Having a similar effect as write-downs, share buy-backs also normally depress shareholders' equity proportionately far more than they depress earnings. As a result, buy-backs also give an artificial boost to ROE. (For related reading, see How Buybacks Warp The Price-To-Book Ratio.)
Moreover, a high ROE doesn't tell you if a company has excessive debt and is raising more of its funds through borrowing rather than issuing shares. Remember, shareholder's equity is assets less liabilities, which represent what the firm owes, including its long- and short-term debt. So, the more debt a company has, the less equity it has; and the less equity a company has, the higher its ROE ratio will be.
Suppose that two firms have the same amount of assets ($1,000) and the same net income ($120) but different levels of debt: Firm A has $500 in debt and therefore $500 in shareholder's equity ($1,000 - $500), and Firm B has $200 in debt and $800 in shareholder's equity ($1,000 - $200). Firm A shows an ROE of 24% ($120/$500) while Firm B, with less debt, shows an ROE of 15% ($120/$800). As ROE equals net income divided by the equity figure, Firm A, the higher-debt firm, shows the highest return on equity.
This company looks as though it has higher profitability when really it just has more demanding obligations to its creditors. Its higher ROE may therefore be simply a mask of future problems. For a more transparent view that helps you see through this mask, make sure you also examine the company's return on invested capital (ROIC), which reveals the extent to which debt drives returns.
Another pitfall of ROE concerns the way in which intangible assets are excluded from shareholder's equity. Generally conservative, the accounting profession normally omits a company's possession of things like trademarks, brand names, and patents from asset and equity-based calculations. As a result, shareholder equity often gets understated in relation to its value, and, in turn, ROE calculations can be misleading.
A company with no assets other than a trademark is an extreme example of a situation in which accounting's exclusion of intangibles would distort ROE. After adjusting for intangibles, the company would be left with no assets and probably no shareholder equity base. ROE measured this way would be astronomical but would offer little guidance for investors looking to gauge earnings efficiency.
Let's face it, no single metric can provide a perfect tool for examining fundamentals. But contrasting the five-year average ROEs within a specific industrial sector does highlight companies with competitive advantage and with a knack for delivering shareholder value.
Think of ROE as a handy tool for identifying industry leaders. A high ROE can signal unrecognized value potential, so long as you know where the ratio's numbers are coming from.
Active TradingCompanies make choices and assumptions in calculating depreciation, and you need to know how these affect the bottom line.
MarketsDifferences between accrual accounting and cash flows show why net income is easier to manipulate.
Investing BasicsThe acid test measures a company’s short-term liquidity.
Investing BasicsAnnual reports are clearly prepared without any intent to deceive or mislead investors. Still, investors should read them with a dose of skepticism.
Investing BasicsLearn about the two types of liquidity risk: funding liquidity risk and market liquidity risk.
Investing BasicsFinancial statement analysis is the process of reviewing a company’s statements to gain an understanding of its financial health.
Investing BasicsFinancial statement manipulation is an ongoing problem, and investors who buy stocks or bonds should be aware of its signs and implications.
Investing BasicsEarnings reports tell investors how a publicly-traded company is performing, but aren’t always easy to decipher.
Stock AnalysisDiscover the key financial ratios that are important when analyzing the financial health, profitability and efficiency of Starbucks' operations.
Stock AnalysisLearn about Oracle's sales growth rate, debt/equity ratio, return on equity and operating margin, and find out how they affect its stock valuation.
When a stock buyback is announced, it means the issuing company intends to repurchase some or all of the outstanding shares ... Read Full Answer >>
Also known as return on net worth, a company's return on equity (ROE) is a common metric used by investors to analyze profitability. ... Read Full Answer >>
The energy sector, and specifically those companies engaging in upstream activities of oil and gas drilling, provides investors ... Read Full Answer >>
Companies engaged in the manufacturing of forest products, including those that participate in harvesting timber, producing ... Read Full Answer >>
Working capital as current assets cannot be depreciated the way long-term, fixed assets are. In accounting, depreciation ... Read Full Answer >>
If a company has high working capital, it has more than enough liquid funds to meet its short-term obligations. Working capital, ... Read Full Answer >>