If there is one single ratio that every share investor should know about analysing the profitability of a business, it should be none other than return on equity (ROE). Return on equity is arguably the most important formula in business finance. Even the richest stock investor in the world, Warren Buffett, uses it to assess the quality of a company as well. So, what does ROE actually means? How can we make use of it to improve our portfolio performance? We will find it out in this article.
What actually Return on Equity (ROE) is?
Return on equity (ROE) is the amount of net income generated by a company as a percentage of its shareholder’s equity. It measures a profitability of a company by showing how much net profit a company can generate with the money invested from shareholders.
“Return on Equity = Net Income/Shareholder’s Equity”
Return on equity is useful for comparing the profitability of different companies in the same industry. Why same industry? It is because some industries have high ROE as they do not require high levels of assets to operate while other industries maintain a low ROE because they have to invest a lot of their retained earnings in capital expenditure. Companies with high ROE usually involves the technology business and information service that requires low investment in capital expenditure.
Why You Should Consider Companies with High ROE
1. They Utilise Shareholder’s Money Efficiently
ROE compares the efficiency of utilizing shareholder’s capital into generating income and profits among different companies. The higher the return on equity, the more efficient the company’s operation is on making use of shareholders’ funds. A company with high ROE is more favourable to investors than a company with low ROE because investors are more likely to get a high return on investment. So, how much ROE is considered high? An ROE of 15% or more is considered high for me.
A company that could produce a high and consistent ROE over time is like a money compounding machine. The higher the ROE is, the larger the compounding effect, and as a result, the wealthier its shareholders are! Therefore, it is also very common that companies with high ROE have higher PE and PB ratio when compared to low ROE company.
2. They Are Good At Retaining Earnings
A high ROE is not just an indication of a profitable company. It also indicates that a company is good at using its retained earnings efficiently. Retained earnings is a source of capital for businesses. Businesses always keep profits to finance its daily operations. It is an internal source of funding which is free from interest expense. Retained earnings have minimal risks since it does not increase the debt of the company. A high ROE can indicate if a company is using retained earnings to generate revenues. An investor could look at the company’s past financial report to examine it. Look at the retained earnings that the corporation has every year and the ROE in the following year. If the company has been maintaining profits and ROE is increasing, it means that the firm is generating revenues from the retained earnings. If a company has retained earnings but keeps it in the reserves, the ROE will decline.
3. They Have Huge Economic Moat
Companies with high ROE have a huge economic moat. Durable companies that have economic moat have the ability to maintain competitive advantages over its competitors by protecting their long-term profits and market share in the market. It pays off, in the long run, to invest in a good quality business. The company with the moat is worth more today because it will generate economic profits for a longer stretch of time. A company has an economic moat should be able to reinvest those cash flows at a high rate of return for a decade or more. However, for a company that does not have a moat, their returns on capital will likely plummet as soon as competitors move in.
How Does A Company Use Debt To Improve ROE
Although companies with high ROE may seem enticing for investors, however, there could possibly be some catch behind the high figures. Investors should be aware of the factors that could affect the ROE value. ROE only shows you how profitable a company is, but it doesn’t tell you how much debt a company has in relation to its equity. Companies can artificially raise ROE by leveraging on debt.
As we all know that shareholder’s equity is equal to total assets minus off total liabilities. Given a fixed amount of assets, the higher amount the of liabilities, the lower the shareholder’s equity. Hence, the lesser equity a company has, the higher its ROE will be.
“Shareholder’s Equity = Total Assets – Total Liabilities”
Here’s an example. Suppose there are 2 identical firms, Firm A and Firm B. They both operate in the same industry, generate the same amount of net income of $100 thousand per year, and have the same amount of total assets of $ 1 million. The only difference between these 2 companies is in their total liabilities and shareholder’s equity. Firm A has a higher total liabilities of $800 thousand, while Firm B has a total liabilities of $200 thousand. Shareholder’s equity in Firm A and Firm B is $200 thousand and $800 thousand respectively. Hence, the ROE for Firm A is a significant 50% and ROE for Firm B is merely 12.5%.
I would like to conclude by sharing some words of wisdom from Buffett as below.
“The best business to own is one that over an extended period can employ large amounts of incremental capital at very high rates of return. The worst business to own is one that must, or will, do the opposite – that is, consistently employ ever-greater amounts of capital at very low rates of return. Unfortunately, the first type of business is very hard to find …”
Source: Berkshire Hathaway 1992 Annual Report
In my opinion, one of the keys to finding stocks that will return investors with exceptional gain often involves acquiring companies that are capable of generating a sustained and outsize return on equity. Time is the friend of a wonderful company, the enemy of the mediocre. However, investors should also note that the price they pay to acquire that business is also important. It is not a wise decision to overpay, no matter how great a company is.