How much are equity investors earning from their investments in companies? The answer is provided by a ratio called return on equity, or ROE.
ROE is explained by Axel Tracy in his book, “Ratio Analysis Fundamentals How 17 Financial Ratios Can Allow You to Analyse Any Business on the Planet.”
Previously, we discussed the difference between return on assets, or ROA, and return on equity. The former includes lenders or borrowed money, as well as investors, while the latter includes only investors. So when we talk about ROE, we’re talking about just investors' money, or equity (also called common stockholder equity).
ROE is always a percentage, and it shows how much shareholders have earned on the money they invested—plus retained earnings (which are also considered stockholder funds).
Bringing back ROA for a moment, Tracy observed, “If the Return on Equity is higher than the return on assets then this means that the business is generating higher returns for its shareholders than it is paying in interest. In effect, it is successfully leveraging borrowed funds. Leverage, or gearing, is using borrowed funds to ‘lever’ your results.”
This means management can generate higher returns than they could with equity only, a good thing for investors. However, debt can also backfire, negatively magnifying, or levering, bad returns if circumstances change.
Return on equity is calculated as:
"Return on Equity = (Net Income – Preference Dividends) / ((Common Stockholder Equity at Start of Period + Common Stockholder Equity at End of Period) / 2)"
Data for this calculation comes from the financial statements:
- Net income: from the income statement (or profit and loss statement).
- Preference dividends (from preferred stock): from the income statement.
- Common stockholder equity at start of period: from the previous balance sheet.
- Common stockholder equity at end of period: from the current balance sheet.
Let’s suppose the figure that emerges from this calculation is 15%. This tells us that for every dollar that investors put into the company, they are getting a return of 15 cents.
GuruFocus members can access ROE directly by going to the profitability section of the summary page of any listed stock. Clicking on the name of the ratio leads them to a page of information about ROE. This example comes from the Caterpillar (CAT, Financial) page and shows how its ROE compares with competing companies:
What does a change in ROE mean? Tracy explained:
“Over time a rising Return on Equity is a very good sign, similar to the return on assets. It generally means that management has improved the overall performance of the business on behalf of the stockholders. This is most likely because net profit has increased in relation to common stockholder equity, and a higher net profit, while all else equal, is always a positive.”
Falling ROE is the flip side of rising ROE, and is generally not a good sign because it means net profit has fallen in relation to common stockholders equity. When it happens, investors may begin to question the effectiveness of the management team.
Tracy also warned that ROE can be questionably manipulated:
“Return on Equity can be manipulated by increasing liabilities deliberately with a corresponding decrease in equity. This can be done, for example, by putting all incoming expenses on credit: this reduces equity (e.g., Debit Expense) and increase liabilities (e.g., Credit Bank Overdraft). Then with an equal profit as previous periods, the reduced equity will have the effect of increasing the Return on Equity. Whether this type of increase is positive is less certain. That is why the relationship between Return on Equity and return on assets must be examined.”
There are a couple of drawbacks to the return on equity concept. First, as mentioned earlier, its manipulation by deceitful managers. Second, and in the same vein, ROE depends on the net profit figure, and net profit can be manipulated or subject to different accounting policies. Tracy added, “Even when deceitful profit manipulation is not the motive, different accounting policies between businesses and industries reduce the effectiveness of this measure.”
Finally, the author had one more consideration:
“There is an important valuation concept that relates to the Return on Equity (ROE) that is worth mentioning. If a business can generate a ROE, which is higher than its cost of capital (the cost it pays for debt, via interest, or the cost it pays for equity, via dividends), then in theory it is ‘creating value.’ This is vital to any business, as the quest for value creation is fundamental premise of enterprise. In theory, if a business can create value then its stock price will be higher than the book value of the shares.”
Note that there is a complementary ratio not mentioned by Tracy. Called WACC versus ROIC (weighted average cost of capital versus return on invested capital), it tells us how much the company is earning versus the amount it is paying for funds investors are providing (ROIC is somewhat similar to return on assets).
It, too, is available to GuruFocus members in the financial section of the summary page. This screenshot shows that Caterpillar’s ROIC is nearly double its weighted average cost of capital:
Conclusion
In assessing the return on equity ratio, Tracy has described it as a key piece of data because it provides in one percentage the return that investors are receiving for placing their money with a company.
A rising ROE is usually good news for investors, while a falling ratio is normally bad news. But note that ROE can be manipulated or vary from company to company because of different accounting policies. One way to guard against potentially misleading figures is to look at the relationship between ROE and ROA.
And, the author advised us that ROE can tell us whether management is creating value with our money by determining if ROE is greater than the cost of capital.
Disclosure: I do not own shares in any company listed, and do not expect to buy any in the next 72 hours.
Read more here:
- Ratio Analysis: Return on Assets
- Ratio Analysis: Gross Profit Margin
- Ratio Analysis: The Profit Margin
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