How Important is ROE for Investors?

Forget head-and-shoulders, bear traps double bottoms, forget volume, and forget stochastics. When you’re looking at a company, the single-most-important number is return-on-equity. Return on Equity is how much profit a Company generates when compared to shareholder equity. What makes ROE so good as a tool to analyze a Company is because it doesn’t account for the price of the stock. It only measures the company’s performance, not the stock’s performance.

ROE = Net Income / Average Shareholder’s Equity

Net Income is the profit that the company generates after expenses and taxes, but before dividends are paid out to common shareholders. Shareholder equity is calculated by subtracting the liabilities of a company from its assets.

What is a good ROE?

In the above example, we see that company one is fully funded by itself and has an ROE of 20%. In the third company, debt is higher than the other 2 and so is the ROE. Whenever we evaluate a company based on its ROE, we have to give due importance to its debt structure. If ROE rises with rising in debt- this isn't a good indicator. It is because higher debt signifies high interest costs.

Bottom line: The ROE of a company is considered to be of good quality only when it rises consistently while the overall debt is either zero or remains the same or decreases. The ideal ROE should be around 17-18%.

Key factors to watch for in looking at ROE

• Debt on the balance sheet- A dishonest management will never have a debt-free business, which is seen from empirical trends. However, this needs to be cross-checked on a case-to-case basis.

• Generation of a high ROE- Companies with shady management are unlikely to report a consistently high ROE over a long time.

• Also important is to find out how a large ROE is generated- is it by excessively leveraging the balance sheet.

Why is it important?

It tells us how the business is growing. If the business adds no additional debt or assets from the year before and profits increase, then ROE will also increase. This would mean that the company is using those same assets more efficiently than before and this is a good thing for investment.

So, it's essential for us to be sure that we are comparing the return on equity of companies with their peers. Another crucial consideration is the pitfalls. Imagine a company that had the same assets and the same profits as the year before. The only thing that has changed is that the company has taken on more debt.

The formula for equity is assets minus debt. If you take on more debt, equity shrinks. If equity shrinks and profits stay the same, the ROE will appear higher. In this case, this is not a real improvement in efficiency, it's merely borrowing money with no growth in profitability and this is a bad thing.

One more hint that Warren Buffett gave the investors in his 1977 letter to shareholders was to beware of companies with a high return on equity. if they also have high debt to equity ratios. This makes sense because that high debt to equity ratio implies that ROE is likely higher for more debt.

ROE is a good test to see if the company is genuinely growing at a respectable rate. Looking closely at ROE will give us a good view of how the company is genuinely performing despite how the stock might be doing. One should try to focus on the long term and not the everyday swings of a rather irrational stock market.

Conclusion

The beauty of ROE is that it works for every company. One can compare General Electric to a lemonade stand. A financial company like JPMorgan has 12 times more assets than equity, but it generates less than a penny of revenue for each dollar of assets. There are two other ways to bump up ROE.

One is by lowering your taxes and the other is by reducing your borrowing costs. Typically, companies aren't in control of these variables. Finally, to conclude- "A company with high debt should be analyzed using ROCE whereas a company with little debt should be analyzed using ROE," said Vivek Mahajan, head of research at Aditya Birla Money.