Profitability Indicator Ratios: Return On Equity
This ratio indicates how profitable a company is by comparing its net income to its average shareholders' equity. The return on equity ratio (ROE) measures how much the shareholders earned for their investment in the company. The higher the ratio percentage, the more efficient management is in utilizing its equity base and the better return is to investors.
As of December 31, 2005, with amounts expressed in millions, Zimmer Holdings had net income of $732.5 (income statement), and average shareholders' equity of $4,312.7 (balance sheet). By dividing, the equation gives us an ROE of 17% for FY 2005.
If the company has issued preferred stock, investors wishing to see the return on just common equity may modify the formula by subtracting the preferred dividends, which are not paid to common shareholders, from net income and reducing shareholders' equity by the outstanding amount of preferred equity.
Widely used by investors, the ROE ratio is an important measure of a company's earnings performance. The ROE tells common shareholders how effectively their money is being employed. Peer company, industry and overall market comparisons are appropriate; however, it should be recognized that there are variations in ROEs among some types of businesses. In general, financial analysts consider return on equity ratios in the 15-20% range as representing attractive levels of investment quality.
While highly regarded as a profitability indicator, the ROE metric does have a recognized weakness. Investors need to be aware that a disproportionate amount of debt in a company's capital structure would translate into a smaller equity base. Thus, a small amount of net income (the numerator) could still produce a high ROE off a modest equity base (the denominator).
For example, let's reconfigure Zimmer Holdings' debt and equity numbers to illustrate this circumstance. If we reduce the company's equity amount by $2 million and increase its long-term debt by a corresponding amount, the reconfigured debt-equity relationship will be (figures in millions) $2,081.6 and $2,682.8, respectively. Zimmer's financial position is obviously much more highly leveraged, i.e., carrying a lot more debt. However, its ROE would now register a whopping 27.3% ($732.5 ÷ $2,682.8), which is quite an improvement over the 17% ROE of the almost debt-free FY 2005 position of Zimmer indicated above. Of course, that improvement in Zimmer's profitability, as measured by its ROE, comes with a price...a lot more debt.
The lesson here for investors is that they cannot look at a company's return on equity in isolation. A high, or low, ROE needs to be interpreted in the context of a company's debt-equity relationship. The answer to this analytical dilemma can be found by using the return on capital employed (ROCE) ratio.
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