Return on Equity (ROE)

What is Return on Equity?

ROE or return on equity expresses the profits generated for shareholders as a percentage of the equity investment. It measures the rate of return equity investors receive on their share investments in the business. It is a useful metric for understanding the profitability of a business and appraising management’s decisions. The metric is particularly important when analyzing a bank’s performance due to the correlation between their ROE and price to book value.

The formula is expressed as:

ROE = Net income / Shareholders’ equity

Where:

• Net income is the profit after all expenses have been deducted for the period. It is also known as the earnings attributable to ordinary shareholders.
• Shareholder’s equity represents the ownership interest in the business. It is the total value of a company’s outstanding shares. Sometimes analysts use average shareholders’ equity as net income is generated over the course of a full year, so it makes sense to use an average number for the denominator to reflect the availability of capital over the same period

Calculating Return on Equity

We have been provided with the following information about a company. How would we calculate the return on equity for this business?

The ROE is 12.0%. This means for every 100.0 invested in by the shareholders generates an annual return of 12.0.

As with all return ratios, it is important to use an appropriate measure of profit depending on what capital is used. Equity is being used as capital; therefore, the net income should be used as profit.

Why is Return on Equity Important for Valuers?

Let us look at three ways ROE can help valuers.

A Measure of Excess Profits

A company can utilize its capital and generate lots of excess profit. This is a positive sign for shareholders as they want to generate as high return as possible on their investments. Excess profits can contribute to increased share price and equity value of a company. Investors feel more confident in the company’s ability to generate returns and this is reflected by the increase in the share price.

Indicator of Management’s Ability

Return on equity is a good indicator of management’s ability to increase value. If a company’s management make sensible investments that return lots of excess profits, it will result in a higher return on equity. A high ROE indicates that management is conducting its duties efficiently. A key way of measuring excess profits is to compare the return on equity with a measure of the company’s expected return on equity, also known as its cost of equity. The expected return on equity to the investor is the cost of equity to the company. The return on equity is the actual return on equity capital invested, while the cost of equity is the expected return. If a company generates a return on equity higher than its cost of equity its share price should rise.

For Aiding Comparison

Finally, ROE is an excellent aid for comparing different companies. However, merely looking at the ROE of an individual company will not be of much benefit. The metric is best understood when compared with a company’s ROE from previous years or the ROE of comparable companies.

Return based calculations can be problematic in industries where a lot of the investment is in intangible assets, for example, brands. If the company is generating brand value by advertising, the accounts will immediately expense the advertising cost, unlike capital expenditure which is capitalized as part of property plant and equipment. So companies with large internally developed intangible assets which are not reflected on the balance sheet will have relatively low equity as the cost of the intangibles are expensed immediately, and relatively high return on equity. In contrast, a manufacturer of heavy industrial equipment requires a lot of capital to run its business all of which is capitalized as PP&E. The manufacturer will have a relatively lower ROE than the company with lots of internally developed intangibles.

Effect of Debt on Return on Equity

Debt or leverage can skew a company’s return on equity. Debt exaggerates the ROE down in bad economic climates and up in good economic climates. Let us understand this with an example of two companies under two different profitability scenarios.

Debt Exaggerates ROE Up

Company A is funded by 1000.0 of equity. Company B is funded by 700.0 of debt, 300.0 of equity and pays a 5.0% interest on its debt.

In the scenario below, business is booming, and both companies are enjoying a healthy operating profit.

Company A does not have to pay any interest and reports a higher net income compared to company B. The return on equity is 17.3% for Company B compared to only 8.0% for Company A.

Debt Exaggerates ROE Down

The numbers above may suggest that it is good for a company to have a higher proportion of debt compared to equity. However, in a bad economic climate, the operating profit is likely to decrease and excess debt can be a disadvantage. Interest on debt is a fixed cost and must always be paid no matter the profits generated by the business. This can substantially reduce the net income available to shareholders. Let us look at companies A and B again with a lower operating profit.

Here, a drop in operating profit (from 100 to 45) has substantially reduced the companies’ net income. As a result, Company B, with a higher interest expense, is giving a lower return on equity as compared to Company A.

The company with much higher leverage, may have a higher return on equity in good times, but it will also have a higher cost of equity (expected return) as equity investors will expect a higher return for taking more risk due to the higher leverage.