What is Return on Equity (ROE)

Return on equity (ROE) is a measure of financial performance calculated by dividing net income by shareholders' equity. Because shareholders' equity is equal to a company’s assets minus its debt, ROE could be thought of as the return on net assets.

ROE is expressed as a percentage and can be calculated for any company if net income and equity are both positive numbers. Net income is calculated before dividends paid to common shareholders and after dividends to preferred shareholders and interest to lenders.

Relatively high or low ROE ratios will vary significantly from one industry group or sector to another. When used to evaluate one company to another similar company the comparison will be more meaningful. Even within the same industry group, comparing the ROE of a company that pays a large dividend with a firm that doesn’t can also be misleading.

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Return On Equity (ROE)

BREAKING DOWN Return on Equity (ROE)

Net income over the last full fiscal year, or trailing twelve months, is found on the income statement: a sum of financial activity over that period. Shareholders' equity comes from the balance sheet: a running balance of a company’s entire history of changes in assets and liabilities. It is considered best practice to calculate ROE based on average equity over the period because of this mismatch between the two financial statements.

Average shareholder equity is calculated by adding equity at the beginning of the period to equity at the end of the period and dividing by two. Investors can use quarterly balance sheets to calculate an even more accurate equity average.

Imagine a company with an annual income of $1,800,000 and average shareholders' equity of $12,000,000. This company’s ROE would be 15%.

ROE = $1,800,000/$12,000,000 = 15%

It is not a good practice to compare the ROE of one company to another if they are very dissimilar, however, it is a common shortcut for investors to consider a ROE near the long-term average of the S&P 500 (14%) as an acceptable ratio and anything less than 10% as poor.

Using Return on Equity to Estimate the Growth Rate

Although there may be some challenges, ROE can be a good starting place for developing future estimates of a stock’s growth rate and the growth rate of its dividends. These two calculations are functions of each other and can be used to make an easier comparison between similar companies.

To estimate a company’s future growth rate, multiply ROE by the company’s retention ratio. The retention ratio is the percentage of net income that is “retained” or reinvested by the company to fund future growth.

Assume that there are two companies with an identical ROE and net income, but different retention ratios. The first company, DivCo, has an ROE of 15% and returns 30% of its net income to shareholders in a dividend, which means DivCo retains 70% of its net income. The second company, GrowthCo, also has an ROE of 15% but returns only 10% of its net income to shareholders for a retention ratio of 90%.

DivCo Growth Rate (10.5%) = ROE (15%) X Retention Ratio (70%)

GrowthCo Growth Rate (13.5%) = ROE (15%) X Retention Ratio (90%)

This analysis is referred to as the sustainable growth model. Investors can use this model to make estimates about the future and to identify stocks that may be risky because they are running ahead of their sustainable growth ability. A stock that is growing slower than its sustainable rate could be undervalued, or the market may be discounting risky signs from the company. In either case, a growth rate that is far above or below the sustainable rate warrants additional investigation.

This comparison seems to make GrowthCo look more attractive than DivCo, but it ignores the advantages of a higher dividend rate that may be favored by some investors. We can modify the calculation to make an estimate of the stock’s dividend growth rate which may be more important to income investors.

The dividend growth rate can be estimated by multiplying ROE by the payout ratio. The payout ratio is the percentage of net income that is returned to common shareholders through dividends. This formula gives us the sustainable dividend growth rate, which favors DivCo.

DivCo Dividend Growth Rate (4.5%) = ROE (15%) X Payout Ratio (30%)

GrowthCo Dividend Growth Rate (1.5%) = ROE (15%) X Payout Ratio (10%)

A stock that is growing its dividend far above or below the sustainable dividend growth rate may indicate risks that need to be investigated.

Using Returned on Equity to Compare Stocks

A good or bad ROE will depend on what is normal for a stock’s peers. For example, utilities have large asset and debt accounts on the balance sheet compared to a relatively small amount of net income. A normal ROE in the utility sector could be 10% or less. A technology or retail firm with smaller balance sheet accounts relative to net income may have normal ROE levels of 18% or more.

A good rule of thumb is to target an ROE that is equal to or just above the average for the peer group. For example, assume a company, TechCo, has maintained a steady ROE of 18% over the last few years compared to the average of its peers, which was 15%. An investor could conclude that TechCo’s management is above average at using the company’s assets to create profits.

How Return on Equity Can Identify Problems

It’s reasonable to wonder why an average or slightly above average ROE is good rather than an ROE that is double, triple, or even higher the average of their peer group. Aren’t stocks with a very high ROE a better value? Sometimes an extremely high ROE is a good thing if net income is extremely large compared to equity because a company’s performance is so strong. However, more often an extremely high ROE is due to a small equity account compared to net income, which indicates risk.

Inconsistent Profits

Imagine a company, LossCo, that has been unprofitable for several years. Each year’s losses are on the balance sheet in the equity portion as a “retained loss.” The losses are a negative value and reduce shareholder equity. Assume that LossCo has had a windfall in the most recent year and has returned to profitability. The denominator in the ROE calculation is now very small after many years of losses which makes its ROE misleadingly high.

In this case, a very high ROE was helpful because it would have alerted investors that LossCo doesn’t yet have a consistently profitable track record. An investment in a stock like LossCo would be riskier than those with stable profit trends and a lower ROE.

Excess Debt

If a company has been borrowing aggressively, it can increase ROE because equity is equal to assets minus debt. The more debt a company borrows, the lower equity can fall. A common scenario that can cause this issue occurs when a company borrows large amounts of debt to buy back its own stock. This can inflate Earnings Per Share (EPS) but it doesn’t affect actual growth rates or performance.

Negative ROE

If a company has negative net income (losses) then ROE is usually not calculated. However, if a company has negative equity because of a prior period of losses, excessive borrowings, or a long-term pattern of share buybacks, ROE can become negative because the denominator in the calculation is a negative number.

If ROE is negative, the most common issue is excessive debt or inconsistent profitability. However, there are exceptions to that rule for companies that are profitable and have been using cash flow to buy back their own shares. For many companies, this is an alternative to paying dividends and it can eventually reduce equity (buybacks are subtracted from equity) enough to turn the calculation negative.

In all cases, negative or extremely high ROE levels should be considered a warning sign worth investigating. In rare cases, a negative ROE ratio could be due to a cash flow supported share buyback program and excellent management, but this is the less likely outcome. In any case, a company with a negative ROE cannot be evaluated against other stocks with positive ROE ratios.

Summary

Return on equity is the ratio of net income (profits) to equity or net assets (assets - liabilities). ROE is considered a measure of how effectively management is using a company’s assets to create profits. Sustainable growth rates and dividend growth rates can be estimated using ROE assuming that the ratio is roughly in line or just above its peer group average. Using ROE to compare stocks can be helpful, but investors should be careful of comparison between stocks that are very dissimilar or with different dividend strategies.

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