1. Profitability Indicator Ratios: Introduction
  2. Profitability Indicator Ratios: Profit Margin Analysis
  3. Profitability Indicator Ratios: Effective Tax Rate
  4. Profitability Indicator Ratios: Return On Assets
  5. Profitability Indicator Ratios: Return On Equity
  6. Profitability Indicator Ratios: Return On Capital Employed

Warren Buffett has reportedly said that Return on Equity (ROE) is his favorite metric. That doesn’t mean it has to be your favorite metric, but ROE sees widespread use for good reason. Any serious student of fundamental analysis needs to know this metric and its limitations cold.

Mathematically, ROE is simple:

ROE is a true bottom-line profitability metric, comparing the profit available to shareholders to the capital provided or owned by shareholders. In a conceptual sense, it’s the profitability measure that equity investors care most about. Whereas return on assets (see the prior article in this series) and return on invested capital each depict a variant of profitability available to both debt and equity investors, ROE stays pure, comparing the income available to just equity investors to the capital owned (and put to work) by just equity investors.

For WD-40, the sample company we’re using in this series, 2016 ROE can be computed as follows:

WD-40 ROE = $52.628m / (($140.395m + $157.858m) / 2) = 35.2%

You can see from WD-40’s 10-K (or you can just trust us) that we’re averaging end-of-year book values for shareholder’s equity for 2016 ($140.395m) and 2015 ($157.858m) to get the ROE denominator.

A two-period average is most common. Some people use only the most recent shareholders’ equity number, but some people use dairy products past the date printed on the package, too. Theoretically, because we’re comparing profit generated to equity capital used throughout the year, the more data points the better, so thorough analysts average quarterly figures.

So is 35.2% good?

In 2017, data compiled by New York University finance professor Aswath Damodaran showed that the average ROE of more than 7,400 US publicly traded firms was 10.38%. So at least roughly speaking, WD-40’s ROE looks pretty good.

From a distance, ROE is simple enough. Now let’s get closer.

ROE: P/E’s Brother From Another Mother

If you’ve heard of the price-to-earnings (P/E) ratio, you’ve seen ROE’s half-brother.

P/E, as we know, divides stock price by net income per share. For example, a $100 stock with $10 in net income per share last year would have a P/E of 10. We can compute P/E on an aggregate level, too: A company with a $100 million market capitalization and $10 million in net income would also have a P/E of 10.

If we flip P/E, we get E/P, or earnings yield. For instance, divide $10 million in net income by $100 million in market cap and you get a 10% earnings yield.

Now, just replace the market value of equity with the book value and you’ve got ROE. A market value of equity denominator shows how much a company earns per the value the market assigns it (a valuation concept), whereas a book value denominator shows earnings relative to the internal equity it had to work with (arguably closer to an operational profitability concept).

ROE: Betrayed by Book Value

Warren Buffett traditionally defined success for Berkshire Hathaway as an increasing book value of equity. It’s natural, if not axiomatic, that anyone who loves ROE trusts book value of equity. But there are many reasons not to trust book value of equity. Book value is reliable for banks, and sometimes for old-school “hard asset”-type companies, but if the goal is an accurate measure of operational returns, it can be problematic as the denominator for ROE in many situations, especially with modern business models and corporate practices.

 We discuss some of those situations below. Note that for best comparison, adjustments need to be equally applied across the full comparison set, whether a company’s own prior financial history, competitors’, or both.

Factors that could skew book value of shareholders’ equity high (and thus ROE low)

Common adjustments (or notes)

High cash balance

Remove cash from shareholders’ equity value and, ideally, remove interest income from net income, adjusting for tax effects.

Goodwill

Remove goodwill, or at least goodwill deemed excessive, from shareholders’ equity. Not all analysts would make this adjustment; their logic is that excessive payment for acquisitions is a company’s “own stupid fault” and that a company should fairly be expected to earn a return on what it bought.

Factors that could skew book value of shareholders’ equity low (and thus ROE high)

Common adjustments (or notes)

Buybacks

Because buybacks reduce shareholders’ equity, some analysts add back recent-year buybacks to offset.

Write-downs

Write-downs are usually done for good reason (and usually not often enough), so many analysts would consider them explanatory factors to be aware of more than accounting quirks to be undone.

Profit after a long period of losses

Cumulative profits, at least those not paid as dividends, boost equity as “retained earnings” on the balance sheet. Cumulative losses do the opposite: they lower book value. As with write-downs, meaningful negative retained earnings shouldn’t be reversed simply to get a more normal-looking ROE, but analysts should note they make the metric relatively less relevant.

Research & Development (R&D) costs

Since 1975, US companies have been required to expense, rather than capitalize, R&D costs. Capitalizing R&D goes beyond the scope of this article, but basically entails adding a multiple or partial sum of prior-years’ R&D expenses to shareholders’ equity (capitalizing means putting something onto the balance sheet) while swapping actual R&D expense for an amortized accrual version (based on expected life of the R&D asset) on the income statement.

For WD-40, the first thing that jumps out is that while the company has grown net income over the years, shareholders’ equity actually declined from 2015 to 2016, from roughly $158 million to $140 million. Obviously, something weird is afoot.

WD-40’s High ROE: Strong Results, Plus Buybacks

Fortunately, people with questions about shareholders’ equity have somewhere to turn: The statement of shareholders’ equity. WD-40’s shows that equity was increased by $53 million in earnings, then reduced by three main things: $24 million in dividends paid, $32 million in stock repurchased (incidentally, a telltale sign of a habitual repurchaser is a big negative treasury stock account on the balance sheet), and $19 million in foreign currency adjustments at subsidiaries.

In terms of keeping the spirit of ROE, the net income and dividends are fine. There’s some accounting theory debate about which foreign currency costs should be on the income statement (i.e., affecting net profit) and which should get “buried” in other comprehensive income, or OCI (which, despite its name, is a balance sheet account), but we’ll sidestep that debate for now, especially because foreign currency adjustments tend to ebb and flow over the years. This leaves one real culprit: buybacks.

A buyback double-teams the ROE denominator by reducing cash and increasing treasury stock (a “contra” account on the balance sheet that reduces book equity) in a single whammy. This isn’t a trick or WD-40’s fault; like all companies, it’s beholden to the accounting treatment of buybacks. In fact, the companies whose ROEs are most skewed by buybacks are almost invariably among the highest-regarded; they’re the companies that have earned enough cash over the decades to bankroll big share repurchases. Just know that ROE will overstate the here-and-now profitability of the equity capital at work for these companies.

ROE’s Silent Influencer: Debt

In a usage sense, rather than a computational one, the biggest weakness of ROE is that it ignores debt. Yes, that’s also its biggest strength, as we mentioned earlier. See, debt can be friend or foe. Higher debt will, if things go well, increase a company’s resource base and thereby its profits. Because debt financing is usually cheaper than equity financing, companies can enhance returns to shareholders by taking on debt in a sensible proportion (ranging from very high for a safe utility to nothing for a risky biotech). The problem with ROE is that it can’t differentiate between profitability boosts fueled purely by operational gains and those fueled by added leverage.

The Best Is Yet to Come

While ROE is the most directly relevant profitability metric for equity investors, many analysts contend that measuring profitability on an equity level has a few too many quirks and warts to be ideal. Their choice for measuring overall company profit? Return on Invested Capital, which we’ll discuss in the next section of this series.


Profitability Indicator Ratios: Return On Capital Employed
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