Return On Equity
Return On Equity
Return On Equity
Return on Equity
One of the most important profitability ratios is return on equity (or ROE for short).
Return on equity reveals how much profit a company earned in comparison to the
total amount of shareholder equity found on the balance sheet. Shareholder equity
is equal to total assets minus total liabilities. It's what the shareholders "own".
Shareholder equity is a creation of accounting that represents the assets created by
the retained earnings of the business and the paid-up capital of the owners.
By measuring how much earnings a company can generate from assets, ROE offers
a gauge of profit generating efficiency. The relationship between the company’s
profit and the investor’s return makes ROE a particularly valuable ratio to examine.
ROE is equal to a fiscal year's net income (after preferred stock dividends but before
common stock dividends) divided by total equity (excluding preferred shares),
expressed as a percentage. As with many financial ratios, ROE is best used to
compare companies in the same industry.
Return on equity is particularly important because it can help you cut through the
garbage spieled out by most CEO's in their annual reports about, "achieving record
earnings". Warren Buffett pointed out years ago that achieving higher earnings
each year is an easy task. Why? Each year, a successful company generates profits.
If management did nothing more than retain those earnings and stick them in a
simple savings account yielding 4% annually, they would be able to report "record
earnings" because of the interest they earned. Were the shareholders better off?
Not at all. This makes obvious that investors cannot look at rising per-share
earnings each year as a sign of success. The return on equity figure takes into
account the retained earnings from previous years, and tells investors how
2 Return on Equity
effectively their capital is being reinvested. Thus, it serves as a far better gauge of
management's fiscal adeptness than the annual earnings per share.
For that reason, a finance executive at E.I. du Pont de Nemours and Co., of
Wilmington, Delaware, created the DuPont system of financial analysis in 1919.
That system is used around the world today and will serve as the basis of our
examination of components that make up return on equity.
The three-step equation breaks up ROE into three very important components:
The five-step, or extended, DuPont equation breaks down net profit margin further.
From the three-step equation we saw that, in general, rises in the net profit margin,
asset turnover, and leverage will increase ROE. The five-step equation shows that
increases in leverage don't always indicate an increase in ROE.
3 Return on Equity
• The company's tax burden is (Net profit ÷ Pretax profit). This is the
proportion of the company's profits retained after paying income taxes.
• The company's interest burden is (Pretax profit ÷ EBIT). This will be 1.00 for a
firm with no debt or financial leverage.
Basic formula
SGR assumptions
• the company grows sales as rapidly as market conditions permit;
ROE
Return on equity is a basic test of how effectively a company's management uses
investors' money - ROE shows whether management is growing the company's
value at an acceptable rate.
ROA
Return on assets reveals how much profit a company earns for every dollar of its
assets. Assets include things like cash in the bank, accounts receivable, property,
equipment, inventory and furniture. ROA is calculated like this:
But if that company takes on financial leverage, ROE would rise above ROA. The
balance sheet equation - if expressed differently - can help us see the reason for
this: shareholders' equity = assets - liabilities. By taking on debt, a company
increases its assets thanks to the cash that comes in. But since equity equals assets
minus total debt, a company decreases its equity by increasing debt. In other
words, when debt increases, equity shrinks, and since equity is the ROE's
denominator, ROE, in turn, gets a boost. At the same time, when a company takes
5 Return on Equity
on debt, the total assets - the denominator of ROA - increase. So, debt amplifies
ROE in relation to ROA.
Because ROE weighs net income only against owners' equity, it doesn't say much
about how well a company uses its financing from borrowing and bonds. Such a
company may deliver an impressive ROE without actually being more effective at
using the shareholders' equity to grow the company. ROA - because its denominator
includes both debt and equity - can help you see how well a company puts both
these forms of financing to use.
So, be sure to look at ROA as well as ROE. They are different, but together they
provide a clear picture of management's effectiveness. If ROA is sound and debt
levels are reasonable, a strong ROE is a solid signal that managers are doing a good
job of generating returns from shareholders' investments. ROE is certainly a “hint”
that management is giving shareholders more for their money. On the other hand, if
ROA is low or the company is carrying a lot of debt, a high ROE can give investors a
false impression about the company's fortunes.
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.
6 Return on Equity
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.
If, for instance, a company takes a large write-off, the reduction in income (ROE's
numerator) occurs only in the year that the expense is charged; the write-off
therefore makes a more significant dent in shareholder equity (the denominator) in
the following years, causing an overall rise in the ROE without any improvement in
the company's operations. Having a similar effect as write-offs, share buy-backs
also normally depress shareholders' equity proportionately far more than they
depress earnings. As a result, buy-backs also give an artificial boost to ROE.
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.
Suppose that two firms have the same amount of assets (Rs.1, 000) and the same
net income (Rs.120) but different levels of debt: Firm A has Rs.500 in debt and
therefore Rs.500 in shareholder's equity (Rs.1, 000 - Rs.500), and Firm B has Rs.200
in debt and Rs.800 in shareholder's equity (Rs.1, 000 - Rs.200). Firm A shows an
ROE of 24% (Rs.120/Rs.500) while Firm B, with less debt, shows an ROE of 15%
(Rs.120/Rs.800). As ROE equals net income divided by the equity figure, Firm A, the
higher-debt firm, shows the highest return on equity.
This company looks as though it has higher profitability when really it just has more
demanding obligations to its creditors. Its higher ROE may therefore be simply a
mask of future problems.
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.
shareholder equity base. ROE measured this way would be astronomical but would
offer little guidance for investors looking to gauge earnings efficiency.
Conclusion
No single ratio 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.
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.