Return on Equity and Capital
Identifies well managed companies!

Return on equity (ROE) and return on capital employed (ROC) are measures of how well a company is being managed.

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

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

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

ROC indicates how well the company is making use of its borrowings.

How do I use them? - I look for ROE and ROC exceeding 15% since it is these returns that add to shareholder value.

Coupled with low debt and a significant re-investment of earnings helps to ensure 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 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 companies

However, 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, as the benefits of these acquisitions may not yet had the chance to flow through to earnings.

Hence 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.

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.

Return from Return on Equity to Financial Measures