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.

ROE Calculation
A company's ROE ratio is calculated by dividing the company's net income by its shareholder equity, or book value. The formula is simple:

Net Income
Shareholders\' Equity

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.

Conclusion
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.

Related Articles
  1. Investing

    How To Calculate Minority Interest

    Minority interest calculations require the use of minority shareholders’ percentage ownership of a subsidiary, after controlling interest is acquired.
  2. Investing Basics

    3 Companies That Hate Debt Financing

    Learn how companies such as Chipotle, Bed Bath & Beyond, and Paychex are able to maintain impressive levels of growth without debt financing.
  3. Technical Indicators

    Key Financial Ratios to Analyze The Automotive Industry

    Learn about the most critically important financial ratios investors and market analysts utilize to evaluate companies in the automotive industry.
  4. Fundamental Analysis

    The Economics of FanDuel

    Part of fantasy sports’ success lies in one-day and week-long contests serving as an alternative to season-long games. FanDuel, a leader in this space, has recently surpassed a $1 billion valuation.
  5. Personal Finance

    Invest in Costco? First Understand Its Balance Sheet

    A strong balance sheet sets a company apart and boosts investor confidence. How healthy is Costco based on an analysis of its balance sheets from the last two years?
  6. Active Trading Fundamentals

    Oil Exploration Companies Pose High Risk for Investors

    Learn why oil exploration companies pose high risks for investors. Oil exploration stocks are highly leveraged to the price of crude oil.
  7. Stock Analysis

    3 High-Yield Investment Grade Stocks You Should Consider

    Discover three high-yield investment-grade stocks for income and appreciation. Interest rate risk is the largest source of risk for investors.
  8. Term

    What is Incremental Cost?

    Incremental cost is the added cost of manufacturing one more unit.
  9. Term

    What is Horizontal Analysis?

    Horizontal analysis compares a company’s balance sheet or income statement over two or more accounting periods.
  10. Stock Analysis

    How MetLife Became a Global Insurance Giant

    MetLife is the largest life insurer in the United States. Here's how it has managed to stay on top.
RELATED TERMS
  1. Revenue

    The amount of money that a company actually receives during a ...
  2. Balance Sheet

    A financial statement that summarizes a company's assets, liabilities ...
  3. Equity

    The value of an asset less the value of all liabilities on that ...
  4. Profit Margin

    A category of ratios measuring profitability calculated as net ...
  5. Operating Margin

    A ratio used to measure a company's pricing strategy and operating ...
  6. Current Assets

    A balance sheet account that represents the value of all assets ...
RELATED FAQS
  1. In what situations does it benefit a company to buy back outstanding shares?

    When a stock buyback is announced, it means the issuing company intends to repurchase some or all of the outstanding shares ... Read Full Answer >>
  2. What is the average return on equity for a company in the financial services sector?

    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 >>
  3. What is the average return on equity for a company in the oil & gas drilling sector?

    The energy sector, and specifically those companies engaging in upstream activities of oil and gas drilling, provides investors ... Read Full Answer >>
  4. What is the average return on equity for a company in the forest products sector?

    Companies engaged in the manufacturing of forest products, including those that participate in harvesting timber, producing ... Read Full Answer >>
  5. What is the formula for calculating compound annual growth rate (CAGR) in Excel?

    The compound annual growth rate, or CAGR for short, measures the return on an investment over a certain period of time. Below ... Read Full Answer >>
  6. What are some examples of general and administrative expenses?

    In accounting, general and administrative expenses represent the necessary costs to maintain a company's daily operations ... Read Full Answer >>

You May Also Like

Trading Center
×

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!