One of the easiest ways an investor can use to gauge whether a company is an asset creator or cash user is to look at its return on equity (RoE) ratio. On the other hand, this indicator might not necessarily tell the whole story about the company and hence, must be used carefully. Here, we dig deeper into return on equity, what it means and how it is used in practice.
RoE measures how well a company generates profits for its owners. It is defined as the business’ net income relative to the value of its shareholders’ equity. It reveals the company’s efficiency at turning shareholder investments into profits. In its simplest form, RoE is calculated by dividing the annual earnings of the company by average shareholder equity during that year.
One can find the income earned by the company on the income statement, or one can also take the sum of the last four quarters’ worth of earnings. Shareholders' equity, meanwhile, is located on the balance sheet and is simply, the difference between total assets and total liabilities. This represents the tangible assets that have been produced by the business.
Industry benchmarking & trends
Investors are constantly on the lookout for companies with a competitive advantage—a feature that normally translates into superior returns for investors. And to find companies with such competitive advantages, one could use a five-year average of the RoE of companies within the same industry.
RoE can be used as an industry benchmark while a company with a relatively higher RoE than its industry peers can be considered to have a competitive advantage. Additionally, RoE can offer insights into a company’s financial management or its ability to grow business by leveraging equity. It is important to compare the RoE among companies in the same industry and a definition of a ‘high’ or ‘low’ RoE should be made within this context. This is because some industries tend to have higher returns on equity than others (or require less equity capital to operate).
You want to make sure that your investment is more than just a flash in the pan. RoE can be beneficial when used in a trend analysis, which involves plotting the ratio over the years so that it will show you if it is growing or slowing - or if it is at all consistent. This way, you can avoid stocks that have declining or inconsistent RoE.
By only using shareholder’s equity as the denominator, RoE becomes extremely susceptible to financing decisions and this can result in the company significantly boosting RoE by taking more leverage and increasing its risk. The opposite also holds true. A company holding a great deal of excess cash will be penalised with a lower RoE, even though it may be making the responsible decision to hold that cash and wait for the opportune time for a higher return.
Another limitation of the ratio is that since this number is so popular with retail investors, companies often use it to set performance targets that executives need to hit to attain their annual and long-term bonuses. This can encourage executives to manipulate accounting earnings, structure transactions to keep them off the balance sheet, and take on more leverage to boost RoE. Since the number is easy to manipulate, investors can’t know if it is reliable or the result of financial wizardry.
There is no single metric that can provide the perfect tool for examining fundamentals. However, RoE is certainly one of the easiest available metrics out there, and contrasting the five-year averages within a specific industrial sector does highlight companies with a competitive advantage. It is certainly a handy tool for identifying industry leaders, so long as you know where the numbers are coming from.