Stock Market 101: Return on Equity

Overview:

1. What is ROE?

2. How to calculate it.

3. What does it imply?

4. Estimating growth and identifying potential problems.

What is ROE?

Return on equity (ROE) is a measure of financial performance calculated by dividing net income by shareholders' equity. It essentially tells us how effectively a company is using its assets to create profits.

How to calculate it

ROE is expressed as a percentage and can be calculated for any company if net income and equity are both positive numbers. The net income of a company is the amount of income, net of expense, and taxes that a company generates for a given period. It is the total amount of money it makes after removing costs and taxes. The shareholders' equity is calculated using this formula: Shareholders’ Equity=Total Assets − Total Liabilities. Finally, the formula for ROE = Average Shareholders’ Equity/ Net Income.

What does it imply?

Whether the ROE of a certain company is good or bad depends on the industry and its average. For example, the technology industry might have an average ROE of 20%, while the Utilities industry might only have an average of 9%. So, to decide whether a company's ROE is good or bad you must compare it to the specific industry's average. The general rule of thumb that I like to use is: if the ROE of a company is consistently above the industry percentage for two or more years, then I consider it a good stock to invest in. However, you cannot buy a stock based on just this one principle. For example, if the ROE of a tech company is 22% for 3 years, then this is a good sign for the company and a sign that you should look deeper into the company.

Estimating growth and identifying potential problems

Using ROE to Estimate Growth Rates:

The ROE of a company can be a good starting place for developing future estimates of a stock’s growth rate. To estimate a company’s future growth rate, multiply the 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. These can be found on. the balance sheets for companies.

Example: Assume that there are two companies with an identical ROE and net income, but different retention ratios. Company A has an ROE of 15% and returns 30% of its net income to shareholders in a dividend, which means company A retains 70% of its net income. Business B also has an ROE of 15% but returns only 10% of its net income to shareholders for a retention ratio of 90%. For company A, the growth rate is 10.5%, or ROE times the retention ratio, which is 15% times 70%. Business B's growth rate is 13.5%, or 15% times 90%.. This comparison makes business B more attractive than company A to investors,

Using ROE to Identify Problems:

There are a couple of things to keep in mind if the ROE is very high.

Inconsistent Profits

The first potential issue with a high ROE could be inconsistent profits. Imagine a company, LossCo, that has been unprofitable for several years. Each year’s losses are recorded 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.

Excess Debt

A second issue that could cause a high ROE is 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 has, the lower equity can fall. A common scenario is when a company borrows large amounts of debt to buy back its own stock. This can inflate earnings per share (EPS), but it does not affect actual performance or growth rates.

Negative Net Income

Finally, negative net income and negative shareholder equity can create an artificially high ROE. However, if a company has a net loss or negative shareholders’ equity, ROE should not be calculated.

KEY TAKEAWAYS

• Return on equity (ROE) measures how effectively management is using a company’s assets to create profits.

• Whether an ROE is considered satisfactory will depend on what is normal for the industry or company peers.

• As a shortcut, investors can consider an ROE near the long-term average of the S&P 500 (14%) as an acceptable ratio and anything less than 10% as poor.

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