The Return on Equity ratio explained.

The Return on Equity (ROE) is a “profitability ratio” used to measure the profitability of a business in relation to its equity deployed. The ratio shows how efficient (or deficient) the company is at taking the equity investments of its shareholders and deploying that equity and generating income from it.

What is Equity? In short, shareholders equity is the amount of capital the shareholders have invested into the business. Companies can either raise capital for operations by taking on debt (bonds) or issuing more equity to the public markets.

As a rule of thumb, High Return on Equity means the company is doing a better job at converting equity into profits. It’s also a good indicator how your own capital may compound in close assosiation to the companies returns. If the equity return is low, it generally means the company is not able to provide investors with substantial returns as it has not meaningfully deployed its equity (not in all cases).

If a company has a Return on Equity of 20% Compounded Annual Growth Rate CAGR over a 10-year period, it is doing an exceptional job at converting its equity financing into more profits. If we have 2 companies one generating returns on equity of 5% and one generating returns of 15%, what return would you like to compound your own capital at? 15% of course. The return on equity and time period are equally important, a rising equity return is a great way to research what is driving this change over time and extrapolating that out to estimate growth rates.

A high and sustainable return on equity is a good sign for a business. Some industries are better at producing higher returns than others. It can also be a good sign that a business has a competitive edge if it has a higher and prolonged return better than its peers in the same industry, the company is generally doing something right (find out what it is).

What is the Return on Equity formula?

• ROE = Net Income ÷ Shareholders Equity.
• Multiply the result by 100 to get our percent.
• Net Income = Found on the income statement, this is the business income after deducting expenses.
• Shareholders Equity = Found on the balance sheet, this is the shareholders entitlement on the business assets, after all debts are paid OR
• Average Shareholders Equity = Beginning shareholders’ equity plus the ending shareholders’ equity, divided by two.

Why Average Shareholders Equity? Return on Average Equity ROAE is a variation on the standard Return on Equity that some analysts believe offers a more accurate outlook on the general profitability of a business due to the possibility of change in the percentage of owners’ equity among total assets throughout the fiscal year of a company. ROAE takes this into account not just the end value of equity. (I just use ROE).

How to use the Return on Equity formula?

Below are a few examples of how to work out return on equity ratio, the formula is very simple to use. Sometimes we need to figure these things out ourself especially in the micro-cap and small-cap space where there is little to no analyst coverage available.

1 Year	Company A	Company B	Company C
Net Margin	$27,500	$48,712	$680,500
Shareholders Equity	$205,000	$787,120	$1,500,000
Return on Equity	13.41%	6.18%	45.36%

The formula broken down as per the below:

Company A > (27,5000÷205,000) x 100 = 13.41%

Company B > (48,712÷787,120) x 100 = 6.16%

Company C > (680,500÷1,500,000) x 100 = 45.36%

Now we might run out and jump at Company C Ltd, we think it shows a fantastic return for that year of 45.36%. However, if we are using return on equity as a measure of performance we need to see it at a high rate sustained over years and not as a once off. If Company C Ltd showed a return of 45.36% for 1 year and Company A Ltd showed a return of 13.41% for a decade, I know which company I’d research further.

Problems with the ROE Ratio?

DEBT! To me this is the number one problem with the return on equity ratio it can throw fuzzy returns especially if a company is taking on excessive debt. The issue with the ratio is it can be manipulated in a variety of ways such as, the net margin being reported inaccurately (it happens more often than you think) or ignoring certain balance sheet items. It can be massively influenced by leverage and even using different accounting practices can manipulate the final equity return number.

Negative ROE? There can also be a negative Return on Equity which is not inherently bad. If you solely filter for high Returns on Equity in your screening, you may miss out on some start-ups, early-stage companies and even business that are scaling with years of losses ahead before becoming profitable. Companies can have growing profits, rising revenue and show growth signs yet have a negative Return on Equity due to the way equity is reflected on the balance sheet.

In Summary…

The Return on Equity is provides a helpful snapshot of a business to see how it is compounding the equity and using it to generate profits. Using the ROC (Return on Capital) is a far better way to measure how a company is using capital to generate its profits. Sometimes if I screen a lower or negative Return on Equity and then cross check it with other ratios like the ROIC, it will give me the full picture of what is going on.  

Diving into the financial statements can help pull apart a high Return on Equity when using it in combination with Free Cashflow, gross margins and other metrics to see if there is any funny business going on that may impact the return.

I use the ratio as a simple starting point to filter and bring companies with high returns on equity that warrant further due diligence.