Return on Equity (ROE)
Return on Equity is one of the most basic fundamental indicators that investors have to get a very quick glimpse at how well a certain company is performing.
How to Calculate Return on Equity
Return on equity is essentially net income divided by the book value of the firm. So, if a company earned $50 million and had a book value of $500 million, its return on equity would be 10%. In essence, the company earns a tenth of its worth each year in after tax, real net income. Not too bad.
Why Return on Equity is Important
Return on equity shows how a firm performs internally, and how effective the company is at generating profits with what it has. A solid return on equity implies that the company is generating healthy cash flow while keeping its operating expenses and assets at a minimal level, the sign of an effective company.
ROE helps put earnings in perspective. While it would be great to see a firm make $10 billion per year in pure profit, it wouldn’t be so great if the company had a book value of $1 trillion, effectively earnings just 1% on its own value. With that kind of return, the company would be best off to close up shop, sell its assets, and buy government debt, because it would earn far more doing that than doing whatever the hell it was doing before.
Also, with some digging, you’ll be able to see which firms are better poised against their competition and which are the best for a downturn. A firm with a high ROE is likely better able to compete on price, and those firms with the best ROE will likely be the best investments in the long haul. Plus, a company with a better ROE than its peers is probably also likely to have a better financial team, as it has clearly demonstrated to be the most effective and efficient at producing a certain product.
Where Return on Equity Can Go Wrong
When you get into accounting there is always the chance that the books can “be cooked.” While I haven’t ever seen a firm every try to manipulate its ROE numbers on purpose, it can be done unknowingly due to basic accounting practices.
A company that has a large amount of debt, limited assets, but plenty of income will have a much higher ROE than a firm that has no debt, and plenty of hard assets, even if the second firm generates better profits and net profit margins.
Also, large write-downs on assets, depreciation, stock buybacks and other events which reduce book value can have a profound impact on ROE numbers without giving the business any real advantage at all. In fact, a firm could write off a series of bad investments, and then decrease its profits, all the while increasing its return on equity.
Sort Good from Bad
Time is the great equilizer. Just as a technical trader would dilute moving averages with time, fundamental investors should too dilute return on equity numbers with time as well. Since ROE is a number not often used in the very short term, you should look to find return on equity numbers going back at least five years. This way, you’ll avoid the complications of short term accounting decisions and get a better sense of what companies really have the upper hand on their competition.
