Understanding Return on Equity

If you give some management teams a couple of boards, some glue, and a ball of string, they can build a profitable growing business, while other teams can’t make a profit with several billion dollars worth of assets.

Return on Equity (ROE) is one measure of how efficiently a company uses its assets to produce earnings. You calculate ROE by dividing Net Income by Book Value. A healthy company may produce an ROE in the 13% to 15% range. Like all metrics, compare companies in the same industry to get a better picture.

While ROE is a useful measure, it does have some flaws that can give you a false picture, so never rely on it alone. For example, if a company carries a large debt and raises funds through borrowing rather than issuing stock it will reduce its book value. A lower book value means you’re dividing by a smaller number so the ROE is artificially higher. There are other situations such as taking write-downs, stock buy backs, or any other accounting slight of hand that reduces book value, which will produce a higher ROE without improving profits.

It may also be more meaningful to look at the ROE over a period of the past five years, rather than one year to average out any abnormal numbers.

Given that you must look at the total picture, ROE is a useful tool in identifying companies with a competitive advantage. All other things roughly equal, the company that can consistently squeeze out more profits with their assets, will be a better investment in the long run.

The articles in this series:

1. Earnings per Share – EPS
2. Price to Earnings Ratio – P/E
3. Projected Earning Growth – PEG
4. Price to Sales – P/S
5. Price to Book – P/B
6. Dividend Payout Ratio
7. Dividend Yield
8. Book Value
9. Return on Equity

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