What Is ROE?
ROE is not an absolute indicator of investment value.The amount of net income returned as a percentage of shareholders equity. Return on equity measures a corporation’s profitability by revealing how much profit a company generates with the money shareholders have invested. 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.The relationship between the company’s profit and the investor’s return makes ROE a particularly valuable metric to examine.
There are several variations on the formula that investors may use:
1. Investors wishing to see the return on common equity may modify the formula above by subtracting preferred dividends from net income and subtracting preferred equity from shareholders’ equity, giving the following: return on common equity (ROCE) = net income – preferred dividends / common equity.
2. Return on equity may also be calculated by dividing net income by average shareholders’ equity. Average shareholders’ equity is calculated by adding the shareholders’ equity at the beginning of a period to the shareholders’ equity at period’s end and dividing the result by two.
3. Investors may also calculate the change in ROE for a period by first using the shareholders’ equity figure from the beginning of a period as a denominator to determine the beginning ROE. Then, the end-of-period shareholders’ equity can be used as the denominator to determine the ending ROE. Calculating both beginning and ending ROEs allows an investor to determine the change in profitability over the period.
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
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.
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.
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.