A Simple Guide to Return on Equity

As an investor, you want to invest in companies which can efficiently generate a higher amount of profit than their rivals. The question is, how would you know if a company is a “profit creator” or a “profit burner”?

Return on Equity (ROE) is the magic wand which can help investors differentiate between the two. Although ROE does not necessary tell you the entire story behind the curtains of a company, it’s nearly always a very important ratio when it comes to picking an investment.

What is Return on Equity?

Return on Equity, also known as also known as Return on Net Worth, measures how much profit a company can generate with the company’s shareholders’ equity.

To put it simply, ROE is the amount of profit generated from each dollar of shareholders’ equity. A return value of 1 indicates that each dollar of shareholders’ equity generates a profit of one dollar.

This is an extremely important measure for potential investors because the efficiency of a company is determined by their ability to turn the invested money into profits. The higher the ROE, the better a company is at generating profit with the equity it has. It also shows how effective the management is utilizing equity financing to grow the business.

Calculating Return on Equity

Here’s the formula for determining Return on Equity:

ROE = Net Income for Full Fiscal Year ÷ Average Shareholder Equity in that Period

ROE is generally expressed as a percentage of shareholders’ equity. Let’s check out how we can calculate Return on Equity using this example:

ROE of AEON CO. (M) BHD

According to the AEON Co.’s Annual Report of 2013, the total equity attributable to the owners of the company was 1,643,637 (RM’000), and 2012 was 1,469,055. The net profit of the company in this time period was 230,962 (RM’000).

aeon-2013

It is easy to find the net profit. But getting Average Shareholder Equity in that period is a little trickier. You will need to find the average shareholders’ equity using this formula:

Average Shareholder Equity (2013-2014)   = (2013 Equity + 2014 Equity) ÷ 2

= (1,643,637+1,469,055) ÷ 2 = 1,556,346

Therefore ROE = 230,962 ÷  1,556,346

= 14.84%

[Knowing how to effectively apply ROE in your analysis can help you make a lot of money. Find Out How We Use ROE to Spot High-Growth Companies]

What Return on Equity Tells You About a Company

So in the above example, Aeon Co. has an ROE of 14.84%. Which means that that for every dollar of investment by shareholders, which is shareholders’ equity, Aeon generates 14.84 cents in net profit.

As you can see, investing in a company with high ROE is considered to be more efficient by shareholders than investing it in a company with low ROE.

A company with consistently high ROE usually means that it is able to constantly generate stable profits, despite economic ups and downs. The company’s business model is resilient and possesses a competitive advantage which protects it during rough times.

It also shows that the company is largely unaffected whenever there is an increase in the costs because they’re be able to pass down costs to consumers without affecting sales. These are some of the most desirable features of a company you want to invest in.

Think about Coco-Cola, Nestlé, Johnson & Johnson, Unilever, etc. All these successful companies have great ROEs and have been growing tremendously for many decades.

Reasons for Low Return on Equity

There are many reasons why a company has low ROE.

One reason is simple because the company isn’t doing so well; revenue and profits are low and they face a tough time growing the business.

Another reason might be that a company be undertaking a high-priced acquisition and for funding the purchase using a large number of shares. The earnings at present might not reap the benefits of these acquisitions, but they might bear fruit in the future. Most companies release a statement or announcement explaining what they do and the effects their actions have on their ROE. This helps investors to understand a company’s strategies better.

Monitoring the ROE of a company from time to time is a good way to know whether the company is still adding value to the market or being left behind by its competitors. A company with constantly rising ROE indicates economic competitiveness. Start-up companies often exhibit high values of ROE, which fall quickly over time.

Generally, when a company has low ROE (less than 10%) for a long period, it simply means that the business is not very efficient in generating profit. In other words, it also tells you that the business is not worth investing in since the management simply can’t make very good use of investors’ money.

Why Too High a Return on Equity Can Be Alarming

When the ROE of a company goes makes a sudden leap, it might be because the company is using debt excessively. As an investor, you need to watch out for this kind of financial leverage. A company can use debt instead of equity to expand their business and generate higher profits. And because profits increase while shareholders’ equity remains the same, ROE in turn goes up. Most investors might consider this a green light for investment, but it fail to notice that the company is taking more debt and, hence, more risk.

For this reason, experts prefer companies which have no or very little debt. When a high ROE is achieved with low debt, this means a company is able to truly generate good returns on shareholders’ equity.

[Knowing how to effectively apply ROE in your analysis can help you make a lot of money. Find Out How We Use ROE To Spot High Growth Companies]

The Fifth’s Perspective

ROE is a vital ratio in investing and a careful investor should consider both ROE and debt levels in order to get a complete picture of the company’s financial performance. So if you’re planning to invest in a company, it would be wise to check out the company’s ROE first!

For more investing tips, insights and strategies, Get Email Updates (it’s free).

KC Lau is the bestselling author of six books including Top Money Tips for Malaysians. His personal finance blog is one of the most visited websites in the Malaysian financial blogosphere. He also hosts regular free financial training classes online featuring various investment and financial experts and co-created a dozen online financial courses. You can follow his latest updates at KCLau.com.

10 Comments

  1. jamaludin

    October 29, 2014 at 12:20 pm

    very clear presentation

    • The Fifth Person

      October 29, 2014 at 2:48 pm

      Thank you Jamaludin. Hope you enjoy the rest of the sharing around this site as well. =)

  2. Orva

    October 29, 2014 at 10:27 pm

    Nice presentation, clear and easy to understand =D

    • KCLau

      October 30, 2014 at 2:23 pm

      Great to hear that Orva.

  3. Chrissie

    October 31, 2014 at 3:51 am

    Hi, what is shareholders’ equity? Is it market capitalisation?

    • The Fifth Person

      October 31, 2014 at 12:47 pm

      Hi Chrissie,

      Shareholders’ equity is the company’s total assets minus its total liabilities. You can watch a quick video explanation here: http://www.investopedia.com/video/play/shareholders-equity/

      Market capitalization is the total dollar market value of a company’s outstanding shares. So if a company has 10 million outstanding shares and each share is worth $10, the company’s market cap is $100 million.

      Hope this helps!

      • Chrissie

        November 1, 2014 at 7:00 pm

        Thank you for the explanation!

        • The Fifth Person

          November 2, 2014 at 11:07 am

          Most welcome, Chrissie!

  4. anon

    November 9, 2014 at 4:31 pm

    Hi,
    One thing to look out for ROE is the debt component as debt inflates ROE.
    I notice that most people, if not all, and esp analysts totally disregard Off-BS liabilities such as Operating Lease commitments & Capital commitments.
    Whilst these are not debts reported in the Balance Sheet, these are nevertheless non-cancellable obligations the company must fulfil.
    Do you include these Off-BS liabilities in your ROE and\or other debt-related ratios (like debt/equity, enterprise value, invested capital, net gearing etc)?
    Hope to hear from you, as this always stump me. Thanks in advance.

    • KCLau

      November 20, 2014 at 10:04 pm

      Good questions!
      Since ROE is affected by the amount of debt, you made a great point here to take a very close look into this.
      Basically, we will look at the debt as wether it is good, or bad ( or not so good).
      For being categorized as “good”, it is debt without incuring expense. So if it is not interest-bearing, it won’t be included.
      What do you think?

Leave a Reply

Your email address will not be published. Required fields are marked *