Fundamental Analysis:Keep Your Eyes on the ROE Chalk Talk | Investing Basics | Analyst | Technical Analy | Fundamental Analy | Options/Futures | Trading | Mutual Funds | Retirement Dictionary Entire Site Articles Tutorials Ask Us Dictionary Term of the Day Buzz Words Tutorials Learn the Basics More Advanced Active Trading Articles Investing Basics Stocks Active Trading Retirement Mutual Funds Options & Futures Ask Us Exam Prep CFA (I, II, III) Series 7 Textbooks & Software Investing Game Open an Account Goto Your Portfolio Tools Calculators Free Trading Kits Coattail Investor ChartAdvisor Newsletters Sign Up Corporate Advertising Licensing Contact Us Keep Your Eyes on the ROE By Ben McClure October 1st, 2003 Printer friendly version It pays to invest in companies that generate profits more efficiently than their rivals. ROE can help investors distinguish between companies that are profit creators and those that are profit burners. On the other hand, ROE might not necessarily tell the whole story about a company and therefore must be used carefully. What Is ROE? By measuring how much earnings a company can generate from assets, ROE offers a gauge of profit-generating efficiency. ROE helps investors determine if a company is a lean, mean profit machine or an inefficient clunker. Firms that do a good job of milking profit from their operations typically have a competitive advantage--a feature that normally translates into superior returns for investors. The relationship between the company's profit and the investor's return makes ROE a particularly valuable metric to examine. To find companies with a competitive advantage, investors can use five-year averages of the ROEs of companies within the same industry. Think of the PC industry: Between 1998 and 2003, Dell Computer's highly-efficient direct sales, high profit-margin strategy paid off in terms of strong earnings and share price appreciation--especially compared with rivals Hewlett Packard and Gateway. The ROE numbers reinforce the differences. Dell enjoyed a whopping five-year ROE of 46% while HP's ROE was only 12%. Over the same period, Gateway's average ROE was negative 2.5%! ROE Calculation A company's ROE ratio is calculated by dividing the company's net income by its shareholder equity, or "book value." The formula is simple: Net Income/Average Common Equity* *Total assets less total liabilities You can find net income on the income statement, but you can also take the sum of the last four quarters worth of earnings. Shareholders equity, meanwhile, is located on the balance sheet and is simply the difference between total assets and total liabilities. Shareholder equity represents the tangible assets that have been produced by the business. Both net income and shareholder equity should cover the same period of time. How Should ROE Be Interpreted? ROE offers a useful signal of financial success since it might indicate whether the company is growing profits without pouring new equity capital into the business. A steadily-increasing ROE is a hint that management is giving shareholders more for their money, which is represented by shareholders' equity. Simply put, ROE indicates know how well management is employing the investors' capital invested in the company. It turns out, however, that a company cannot grow earnings faster than its current ROE without raising additional cash. That is, a firm that now has a 15% ROE cannot increase its earnings faster than 15% annually without borrowing funds or selling more shares. But raising funds comes at a cost: servicing additional debt cuts into net income and selling more shares shrinks earnings per share by increasing the total of shares outstanding. So ROE is, in effect, a speed limit on a firm's growth rate, which is why money managers rely on it to gauge growth potential. In fact, many specify 15% as their minimum acceptable ROE when evaluating investment candidates. ROE Isn't Perfect Still, there are caveats that need to be considered. ROE is not an absolute indicator of investment value. After all, the ratio gets a big boost whenever the value of the shareholder equity, the denominator, goes down. If, for instance, a company takes a large write-down, the reduction in income (ROE's numerator) occurs only in the year that the expense is charged; the write down therefore makes a more significant dent in shareholder equity (the denominator) in the following years, causing an overall rise in the ROE without any improvement in the company's operations. Having a similar effect as write-downs, share buy-backs also normally depress shareholders' equity proportionately far more than they depress earnings. As a result, buy-backs also give an artificial boost to ROE. Moreover, a high ROE doesn't tell you if a company has excessive debt and is raising more of its funds through borrowing rather than issuing shares. Remember, shareholder's equity is assets less liabilities, which represent what the firm owes, including its long and short-term debt. So, the more debt a company has, the less equity it has; and the less equity a company has, the higher its ROE ratio will be. Suppose that two firms have the same amount of assets ($1,000) and the same net income ($120) but different levels of debt: Firm A has $500 in debt and therefore $500 in shareholder's equity ($1,000 - $500), and Firm B has $200 in debt and $800 in shareholder's equity ($1,000 - $200). Firm A shows an ROE of 24% ($120/$500) while Firm B, with less debt, shows an ROE of 15% ($120/$800). As ROE equals net income divided by the equity figure, Firm A, the higher-debt firm, shows the highest return on equity. This company looks as though it has higher profitability when really it just has more demanding obligations to its creditors. Its higher ROE may therefore be simply a mask of future problems. For a more transparent view that helps you see through this mask, make sure you examine also the company's return on invested capital (ROIC), which reveals the extent to which debt drives returns. Another pitfall of ROE concerns the way in which intangible assets are excluded from shareholder's equity. Generally conservative, the accounting profession normally omits a company's possession of things like trademarks, brand names, and patents from asset and equity-based calculations. As a result, shareholder equity often gets understated in relation to its value, and, in turn, ROE calculations can be misleading. A company with no assets other than a trademark is an extreme example of a situation in which accounting's exclusion of intangibles would distort ROE. After adjusting for intangibles, the company would be left with no assets and probably no shareholder equity base. ROE measured this way would be astronomical but would offer little guidance for investors looking to gauge earnings efficiency. Conclusion Let's face it, no single metric can provide a perfect tool for examining fundamentals. But contrasting the five-year average ROEs within a specific industrial sector does highlight companies with competitive advantage and with a knack for delivering shareholder value. Think of ROE as a handy tool for identifying industry leaders. A high ROE can signal unrecognized value potential, so long as you know where the ratio's numbers are coming from. Cheers, Ben McClure Contact Ben StartupJournal.com Visit The Wall Street Journal's center for Entrepreneurs today! Coattail Investor Find out exactly what the world's best investors are buying and selling Term Directory: # | A | B | C | D | E | F | G | H | I | J | K | L | M | N | O | P | Q | R | S | T | U | V | W | X | Y | Z Financial Planning · Stock Exchange Contest · Tax Information Online · Bad Credit Loan · Term Life Insurance Quotes Site Stuff:Advertising · Licensing · Tell-A-Friend · Contact Us · Link To Us · Terms of Use · Privacy Policy · Jobs Newsletter: "The #1 Way to Learn about Investing" More Information Copyright © 1999-2004 - All rights reserved. Owned and Operated by Investopedia Inc.