Understanding ROE
Return on equity, or ROE, is a measure of a company's profitability, which calculates the return that a company is able to generate with its shareholders' equity.
ROE is widely considered one of the most important financial metrics investors use to assess a company's relative performance and its continued ability to generate satisfactory returns and finance its growth aspirations.
This is because ROE shows how efficiently a company uses its equity financing to generate income. If a company has a high return on equity, it can convert the equity capital it raises from shareholders (like you!) into profit.
The more profitable a company, the less reliant it is on debt or capital raises to finance its growth. Both options can be potentially bad for you as a shareholder because high debt repayments can eat into a company's earnings, while capital raises can dilute the company's share price.
This all means that ROE can be one of the most important financial ratios in your toolkit when comparing possible investments. As a potential shareholder, you want to be sure the company you are considering investing in will make the best use of your equity.
Basically, the higher the return on equity, the better bang for your buck.
How to calculate return on equity
We can calculate return on equity using the following formula:
ROE = net income/average shareholders' equity
You can find these numbers in a company's financial statements. Net income will be displayed on a company's income statement, while average shareholders' equity will be on its balance sheet.
For example, a company earning $10,000 net income per year from $100,000 in average shareholders' equity would generate a 10% return on equity.
ROE = $10,000/$100,000 = 0.1 (or 10%)
What is shareholders' equity?
It's essential to explain exactly what we mean by shareholders' equity.
Shareholders' equity is a company's total assets minus its debt. It's sometimes called a company's 'net assets'. You can find this number on a company's balance sheet.
Shareholders' equity equals the amount of money the company's shareholders would be entitled to if the company was suddenly forced to liquidate. First, the company would have to sell its assets to repay its outstanding debts, and then whatever cash was left over would be returned to its shareholders.
What is considered a high ROE?
Generally, an ROE of between 15% and 20% is considered good. But it's important to remember that return on equity measures relative financial performance. Whether a company's ROE is considered high or low depends on how it compares to its peers within its industry.
For example, successful utility companies might tick along with a relatively low and stable ROE of about 5%, while profitable healthcare companies like CSL Limited (ASX: CSL) can regularly deliver an ROE above 40%.
Therefore, it's important to understand the average ROE for companies in the sector and then try to identify which consistently beat that benchmark.
Also, remember that some companies may have a negative ROE because they have yet to post a profit. These companies may have high future growth potential and could still be good investments – but they come with higher risk.
Why is ROE important?
A high ROE means a company can reinvest funds into the business to grow operating earnings without raising additional equity (cash) from its shareholders. A highly profitable company is also less likely to need to borrow extra money from banks or the bond markets because it can finance its ongoing operations with its current earnings.
The ROE metric lets an investor gain insight into a company's performance. It shows how effectively a company manages its money, including prior annual savings (retained earnings).
It also enables an investor to assess how successful the company is at investing its money into other business segments, which often deviate from its core business. Looking at a company's ROE trends can tell you whether new ventures and investments increased or decreased their overall returns.
Finally, ROE analysis can help you identify shares that pay consistent dividends. Mature blue-chip companies will often commit to paying a certain portion of their earnings to investors as dividends each year (referred to as the 'dividend payout ratio'). Companies with the highest returns may also pay the most generous dividends.
Analysing a company using its ROE and dividend payout ratio can help income investors identify good potential investments.
Drawbacks to ROE
Return on equity is an excellent financial metric to use when analysing stocks. It is easy to calculate and interpret. It uses numbers readily available in a company's financial statements and can reveal a lot about the company's profitability.
However, it does have some drawbacks. For example, ROE doesn't consider debt levels. If a company borrows heavily to finance its growth, it can sometimes appear to generate high earnings off a low equity balance.
This is why looking at trends in a company's ROE over several years is always the best approach, rather than just choosing one period in isolation.
For example, those companies that borrow at unsustainably high levels will eventually see their profits eroded by ever-increasing interest and debt repayments, which means their ROE will inevitably decline over time. This would be evident from a trend analysis – as would any other one-offs or anomalies.
You should also always use ROE in combination with other financial metrics and ratios in your analysis. This can reveal more sophisticated information about a company's financial health and help you make better investment decisions.
For example, if you suspect a company's higher ROE is driven by higher debt, you can calculate its debt-to-equity ratio to see how much leverage it uses. If it turns out to be far more leveraged than its peers, you might decide it is too risky to invest in, despite its strong ROE.
What is DuPont analysis?
It is possible to break down a company's return on equity into its main components using the DuPont analysis method.
These components are:
- Net profit margin (calculated as net income/revenue)
- Asset turnover (calculated as revenue/average assets)
- Equity multiplier (calculated as average assets/average shareholders' equity).
We calculate average assets by adding the value of the company's assets in the current and preceding financial year and then dividing by two. These numbers are found on the balance sheets for the two financial years.
If you multiply these three financial ratios, you will get the same number as the simple net income/shareholders' equity formula earlier.
DuPont analysis can be a great way to identify the sources of a company's returns. For example, if a company has a higher equity multiplier than its competitors, a significant amount of its ROE is due to its more leveraged capital structure.
An example of ROE in action
Fast-food chain Domino's Pizza Enterprises Ltd (ASX: DMP) regularly generates a high return on equity. In its FY22 results, covering the 12 months ending 30 June 2022, Domino's reported an underlying net income of $165 million on average equity of a little over $408 million. This means Domino's had an ROE of about 40%.
We can break this down using a DuPont analysis.
- Domino's net income was $165 million, while its revenues were $2,289 million, giving it a net profit margin of 0.07
- Domino's average assets were about $2,392 million, which means its asset turnover was 0.96
- Finally, dividing the company's average assets by its average shareholders' equity gives an equity multiplier of 5.85
- And, just to prove the maths: 0.07 x 0.96 x 5.85 = 0.40, or 40%.
Without even needing to compare Domino's with its competitors, we can see that the company's key driver for its high ROE is its equity multiplier. This means Domino's is relatively highly leveraged, which could pose a risk to profits, particularly as interest rates rise.
What is the difference between ROE, ROI and ROA?
There are many different ways to think about a company's returns. As we've already discussed in this article, ROE measures a company's returns relative to the amount of its shareholder's equity.
However, you can measure a company's earnings relative to other things as well. These metrics can tell you even more information about how good a company is at generating profits.
For example, return on assets (or ROA) measures a company's earnings relative to its assets. This might be a good way to compare two manufacturing companies. It allows you to assess which company is better at generating profits from its assets (like manufacturing plants and facilities).
ROI stands for return on investment. As the name suggests, ROI is a simple measure that calculates the return on any investment. It is easy to calculate yourself; just divide the earnings from a particular investment by its initial cost. For example, if you bought a share for $100, and it was now worth $110, your return would be 10% (the $10 capital gain divided by the initial cost).
You can use ROI to assess all sorts of investments, from shares in your portfolio to real estate to individual company projects. For example, you might want to analyse how well a company's new division performs. To do so, you could tally up the current value of the division relative to its initial costs. This can tell you whether the company has been making sound decisions about where to invest its earnings.
Foolish takeaway
Return on equity is one of the most commonly used return measures in stock analysis. That's because this easy-to-calculate metric effectively measures a company's financial performance over time. It can reveal much information about a company's fundamentals and capital structure in conjunction with other financial ratios.
Companies that continually earn a high return on equity tend to grow their owners' earnings consistently over time and (often) have superior money management teams. This can make them superb investments to add to your portfolio.
