Return on Equity (ROE) – What is Return on Equity?

What is Return on Equity?

Return on Equity is:

ROE is represented as a percentage, and tells the return shareholders receive on their investment.

ROE is a measure of profitability of a company. Some refer to it as a company’s “Profitability Ratio”

The numbers to determine a company’s Return on Equity are found on their Balance Sheet Statement and Income Statement.

Below we are using Intel’s 2012 10-k report as seen on the TradeKing platform.

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Shareholder Equity is on the Balance Sheet: (click images to enlarge)

Net Income is on the Income Statement:

Using the numbers above, we can calculate Intel’s ROE:

Or about 21.5%.

This means that for every $10,000 invested by shareholders in Intel, the company is generating about $2,150 in profits per year.

The higher the percentage, the more “efficiently” the company is creating profits. In other words, a company with a higher ROE is able to make more profits per dollar invested than a company with a lower ROE.

Using ROE for Analysis:

When comparing multiple companies, comparing their ROE’s is a great way to determine which company has the best profitability.

Consider 2 companies:

Company A’s Net Income was $1 million.

Company B’s Net Income was $1 million.

So far, these companies appear to be the same. They make the same amount of profit each year. But as an investor, you have to look deeper than just earnings.

Let’s say that company A required a $10 million investment to get off the ground and running (This $10 million would be the company’s initial Shareholder Equity assuming no other company assets or debt).

While company B required $100 million.

Now is it more obvious which company is better for investors?

Company A required only a $10 million investment to generate $1 million a year in profits, while company B required $100 million to generate the same profit.

ROE for company A is 10%

ROE for company B is 1%

As an investor, if you want to make a million dollars a year, would you rather spend $10 million or $100 million? Easy choice!

However it is important to note that when comparing two different companies’ ROE, ensure they are in the same industry. A technology company will have a much different ROE than a restaurant, just because the industries are so different. So comparing ROE loses its effectiveness when comparing companies from different industries.

Look out for:

There are several things a company can do to show an increase in their Return on Equity, without really improving the company’s financials.

Debt-to-Equity Ratio

The denominator in the equation for ROE is Shareholder Equity, which is simply assets minus liabilities.

This means that as a company takes on more debt its liabilities increase, which reduces Shareholder Equity, which will increase ROE. Now obviously, if a company is taking on way too much debt that is not good… but its ROE number will look amazing.

SO before you think you found a goldmine stock with ROE of 100%, take a look at the increase in liabilities, and make sure the ROE number is not because of increasing debts.

For this reason, often it is favorable to look at a company’s ROE numbers over the past several years. This can tell investors if the earnings trend of the company is positive or negative, and can filter out individual year’s numbers that may have been out of whack because of a debt offering or 1 time event. If over the past 10 years, the company’s ROE has steadily decreased, it means the company is not able to make money like it used to, and needs to be seriously scrutinized before invested in.

Lets look at Intel’s numbers:

Year	2008	2009	2010	2011	2012
ROE	13.38%	10%	23.19%	28.19%	21.50%

The increase from the 2008/2009 recession looks promising, the most recent decline is something investors will want to keep an eye on. But if Intel can keep its ROE up over 20% for the long term, it will lead to great returns for shareholders. Personally, if a companies ROE declines but is still very high, such as greater than 20% like Intel above, it does not cause me as much concern as a company whose ROE is falling and it is low (such as falling below 10%).

Here are some other companies’ ROE numbers. Guess which two Buffett is invested in?

Notice the high, consistent numbers from Coca Cola and Walmart compared to the sporadic (mostly declining) Amazon numbers? Its no wonder Buffet chooses companies like Walmart and Coca Cola who have returned consistently high ROE for decades.

In Conclusion:

In General, a ROE of 15% or greater is considered decent.

ROE gives investors a glimpse at the management’s efficiency in making profits, not just simply how much it earned. ROE gives insights on the company’s margins, revenue, retained earnings and much more, and is a very simple calculation investors should do before investing in a company.

Financial Statements: A Step-by-Step Guide to Understanding and Creating Financial Reports, Defines this as:

“Return on Equity. The Return on Equity (ROE) ratio measures management’s success in maximizing return on the owner’s investment. In fact, this ratio is often called “Return on Investment”, or ROI”.

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