Return on Equity or ROE as it is known is a ratio is a relative valuation metric which uses the net profit generated by the company and its shareholder equity to determine how efficiently the company under consideration is generating its profits when compared to its peers as well as the average of the industry in which it operates.
Unlike other relative valuation metrics, ROE is unique in that it can be used to compare companies across industries and sectors alongside companies in its own unique sector. In essence, ROE tells you how much bang for your buck you are likely to receive from the company where your buck is.
This is an important metric to know irrespective of the sector because even though the company might be the best in the sector but if ROE is low as compared to other sectors, you are better off investing in the high ROE sectors and ignoring the low ROE ones. Knowledge is easily processed when accompanied by an example so let us look at one while we try to understand this ratio in detail.
ROE is quoted in % terms since returns are generally quoted in % terms. It is the ratio of Net Profit of the company divided by the Shareholder Equity of the company.
ROE (%) = (Net Profit or Income / Shareholder Equity) * 100
Both values are available in financial statements of companies with Net Profit available in Income statement and Shareholder Equity in Balance sheet. Shareholder Equity can also be calculated by Subtracting All Liabilities from All Assets.
At its core, ROE measures how much return the company is generating for its shareholders and how efficiently it is growing its capital. An ROE of 30% means that the company is earning 30% on its invested capital every year and a growing ROE means that return is growing as well. That does not mean that all you got to do to invest successfully is identify high ROE companies and invest in them.
This ratio is not the Holy Grail of company evaluation. As with other valuation metrics, there are some drawbacks to its application which we shall see below but it is a handy tool to highlight strong companies in their sectors.
As mentioned in the start, ROE can be sector agnostic. To showcase this special feature of sectorial independence, we shall look at the most popular companies in the world right now: Apple Inc., Amazon Inc., Alphabet Inc. (Google) and Netflix Inc. We shall look at the ROE of these companies and compare them with their performance over last year.
As with other ratios, ROE is independent of currency as long as both Net Profit and Shareholder Equity are considered in the same currency.
If I was an investor looking to make the maximum return, I would want to invest in a high ROE company like Apple. Although share performance is not dependent on ROE alone, a company’s ability to generate high ROE is a significant factor in appreciating share prices. This also highlights one of the drawback of ROE. Just by looking at this numbers it is difficult to make out which is a market leader in their respective sector and which isn’t. Let us look at performances to highlight that better.
Netflix which was a market leader once upon a time has to now compete for its position with several new and powerful entrants like Hulu, Disney+. Apple TV, Peacock, Amazon Prime and many more. Its returns have now lined with its ROE. Apple too has to compete for its phones with several large players like Samsung, Xiaomi and local manufacturers but it continues to remain a large force in its sector aligning its returns with its ROE as well.
Amazon is a market leader in online retailing and continues to dominate the sector. It gained especially high market share during the pandemic when physical retail outlets were shut but online deliveries remain. It has also diversified into other segments like web hosting services where it is again a leader, streaming services and many more. Finally Google who is not only the dominant player in search engines and mobile operating systems with Android but also a paramount example of a pandemic proof business and its investors have been rewarded for that pandemic resilience with a phenomenal appreciation in share price.
ROE might come across as a one stop solution for company valuation and like a siren song which attracts sailors to go overboard their ships, ROE numbers might entice investors to go overboard with their company selection choices. A single ROE number in its absolute is a disaster waiting to happen.
It is influenced by Net Profit and Shareholder Equity. Let us look at Net Profit first. In any one year, the company may have sold a large piece of asset or had a onetime windfall which will be recorded in its Net Profit thus increasing its ROE by default and giving an incorrect impression that the company has grown earnings well. In case of Shareholder equity, a buyback will automatically reduce shareholder equity and increase ROE without any meaningful change in the company’s ability to generate that ROE.
By default, it is recommended to calculate average ROE of 5 years by calculating ROE of each year and then taking their average. A high ROE is no indicator of the debt problem in the company. ROE effectively serves as a speed breaker bump. A company can grow its earnings only as fast as the ROE. For it to increase its ROE, it will have to bring in more cash either via issue of shares which will increase shareholder equity and suppress ROE in short term but improve over long term or take on debt to get that additional cash. A company can simply choose to take on more and more debt which will increase liabilities and reduce shareholder equity (Assets minus Liabilities) thus increasing ROE. So what is high ROE might simply be a debt laden company.
Ideally a high ROE is a good indicator of market leadership of the company in its respective sector. However the same should be established by taking a deep dive in company financials to see if that ROE has come on the back of increasing debt or by virtue of business operations. A high ROE must be backed by sound business practices for it to be a sound investment. Let us look at some companies in the same sector to highlight the drawbacks as well as what we should be looking for.
As you can see, Keurig Dr. Pepper has a low ROE as compared to its giant peers Pepsi and Coca Cola. It has a lower ROE than industry average as well but you will be surprised to see their performance in the last one year.
Surprising isn’t it? The reason behind this requires us to take a peek at their financials!
Pepsi and Coca Cola are highly leveraged as compared to Dr. Pepper and their ROE has been inflated because of that as well. However market is supreme and it has realized that the ROE number is for show and that actual returns will not be as high and the same is reflected in the appreciation of their share price. You can try this exercise out on any sector here at fairvalue-calculator.com itself.
One can get our premium membership for as low as € 7.9 per month. In our premium dashboard, one can use our screener to screen for high ROE stocks.
In the screener above I have input ROE between 15%-100% and the screener has presented me with a fantastic list of 21,740 stocks. I can now apply other filters to shorten the list and then deep dive into the financials of those in the final shortlist. Conclusion: ROE is not a one stop shop for company valuation but it is a powerful tool that helps point investors towards quality companies with a knack of generating shareholder value.
However one must look at other metrics like Price to Book value and Price to earnings along many others to arrive at a consensus of valuation. We have over 12 such key financial ratio calculators on our website, all available for free. Calculate the key ratios and build a consensus through them to determine whether a company is truly undervalued or overvalued. Alternatively, join our premium membership and we will do all of this work for you, providing you various fair values right on your very own premium dashboard.
In my experience, ROE is a good filter to knock out those that destroy shareholder value. Average market returns can be found by a simple Google search.
Ideally you want a company, especially one you wish to invest in to generate a ROE higher than average market return which we can consider on the higher side at 16%. Any company generating ROE lower than this is just burning cash and in the long run will fail because it will be unable to raise any money from the markets and its profits are not enough to grow capital.
An investor too would be better off putting his/her money in an index fund rather than a low ROE company. Once the filter has been applied, other valuation metrics can be used to sift through the high ROE companies and a consensus of valuation metrics can then be used to create a final short list which an investor can then explore in depth before making their investment decision.
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