Return on Equity

Identifies well managed profitable companies!

Terms such as return on equity (ROE), return on capital (ROC) and return on funds employed (ROFE) are measures of how well a company is being managed. They are measures of company profitability as distinct from profit.

A well-managed company can be expected to provide an enhanced return if the business is fundamentally sound.


Calculating ROE

ROE is calculated by dividing the net (tax-paid) profit by the sum of shareholders' 'ordinary' equity and expressing this as a percentage.

ROC and ROFE include the combined return on both earnings and borrowings. ROC and ROFE would be expected to be less than ROE as borrowings involve interest payments.

ROC and ROFE indicate how well the company is making use of its borrowings.


Significance of ROE

I look for ROE and ROC exceeding 15% since it is these returns that add to shareholder value.

Low debt and a significant re-investment of earnings ensures that the company can magnify its performance over time.

Shareholders can’t expect high returns in the long term if the ROE and ROC are low.

Companies with low ROE should be handing back profits to shareholders since retaining earnings to magnify poor performance will destroy value.

Of course, the overall return I get will also depend on the price at which I buy the stock and how long I hold it for.

Time is the friend of well-managed businesses!

A company may lower its ROE because it has recently undertaken a large acquisition and have funded the purchase by issuing more shares.

The increase in the number of shares has the effect of lowering the ROE and ROC, one hopes in the short term. The benefits of these acquisitions may not yet had the chance to flow through to earnings.

So it is important to check the background and announcements that companies make in order to have a better understanding of what they are doing and what effect this may have, if any, on the return on equity.

Their performance in quickly enhancing returns from any previous acquisitions may provide some confidence as to their ability to add value from current take-overs.

Keeping an eye on how a company's ROE grows or fades over a number of years provides an indication on whether the company is adding value or running out of steam.

Young companies that are growing quickly may exhibit large returns on equity which can't realistically be sustained over time.

So a drop in ROE from large values is not necessarily a bad thing - but if a return on equity drops below 15%, I start being concerned.


To Conclude

When searching for wonderful businesses using a stock screener, return on equity greater than 15% is one of the important financial measures I filter on.

Since this is the measure that determines profitability, as distinct from profit.

Return from Return on Equity to Financial Ratios