Why Return on Equity Matters to Investors
When analyzing public companies, there are hundreds of different financial metrics available to investors. Most of these metrics track a company’s profitability, such as revenue, profit margins, and earnings per share. However, few investors pay as much attention to one of the most valuable metrics available: Return on Equity (ROE).
ROE measures how efficiently a company uses shareholders’ capital to generate profits. Companies with strong ROEs are typically considered to have higher levels of efficiency in how they operate their business. However, ROE should never be viewed in isolation. Professional investors use ROE as part of their evaluation of companies to determine what they should expect from their investments.
What Is Return on Equity?
Return on Equity (ROE) is a metric that helps investors compare a company’s net income to its shareholders’ equity.
In other words, ROE indicates how much profit is generated for every dollar that is invested by shareholders in the company. ROE can be calculated by dividing a company’s net income by its shareholders’ equity.
Higher ROEs indicate that a company is using shareholders’ capital more efficiently than companies with lower ROEs. However, there is no universally-accepted benchmark for what is considered to be a strong ROE. The ratio will vary depending on the company’s industry and business model.
Why ROE Is Important
ROE is a valuable metric for evaluating how well a company manages its capital to generate profits for shareholders. A strong ROE may indicate that a company features efficient operations, high levels of profitability, effective capital management, strong competitive advantages, or that it is run by high-quality management team.
Rather than focusing solely on how well a company is profitable, ROE allows investors to determine how efficiently the company produces its profits.
Comparing Companies Using ROE
ROE is most valuable for comparing companies within the same industry. Many investors may use ROE to compare the following company types:
Banks
Insurance companies
Software companies
Manufacturers
Health care companies
However, comparing companies within different industries using ROE may produce misleading conclusions.
High ROE Doesn’t Always Mean High Quality
While companies with high ROEs often attract investors interested in profiting from the company’s successes, a high ROE does not necessarily indicate that the business is of high quality.
ROE can increase for a variety of reasons, such as higher profitability rates, share repurchase programs, lower equity values from shareholders, and higher levels of financial leverage.
A high ROE driven by financial leverage indicates that the company is of higher financial risk than one with a similar ROE but lower levels of leverage.
ROE and Competitive Advantage
Companies with ROEs above the industry average may indicate that the company has competitive advantages allowing them to generate higher profits than their competitors.
These competitive advantages may include having:
Strong brands
Proprietary technology
Network effects
Pricing power
Strong customer loyalty
Operational efficiency
Companies that produce higher returns for shareholders often exhibit these attributes.
A company may have a high ROE in a given year, but the ability to maintain that ROE over several years indicates that they have competitive advantages that provide sustained profitability.
ROE and Capital Allocation
The ROE that a company produces is also directly related to how its management team allocates the company’s capital.
Management must decide how to allocate a company’s capital to areas such as:
Expanding the company
Purchasing new technology
Reducing debt
Purchasing shares back from shareholders
Paying dividends to shareholders
Making strategic acquisitions of other companies
A company’s management team can use ROE as a metric to determine which of these strategies will help the company increase its profitability and ROE.
Limitations of Return on Equity
Despite being a valuable metric for evaluating companies, there are a few limitations to ROE investors should be aware of.
ROE does not consider a company’s:
Debt levels
Accounting measures
Industry
One-time gains and losses
Share repurchase programs
Many of these factors may affect a company’s ROE in a single year but not others over several years. Therefore, relying solely on ROE to evaluate a company may provide incorrect conclusions.
Combining ROE with other financial metrics may provide a more complete picture of a company’s financial health.
Metrics That Complement ROE
Investors analyze a variety of financial metrics alongside ROE to form a well-rounded opinion of a company’s financial health. Metrics like ROIC, ROA, free cash flow, operating margins, revenue, and the debt-to-equity ratio can all help provide a well-rounded view of a company.
Using a variety of financial metrics helps to reduce the risk of making incorrect conclusions about the company based on only one metric.
Key Takeaways
Return on equity is a metric that compares how much profit a company generates with the capital that its shareholders invested in the company.
High ROEs typically mean that the company has efficient operations and management.
ROE best works when comparing companies within the same industry.
High ROE does not indicate high quality; it should be analyzed alongside the company’s debt and capital allocation decisions.
Analyzing a company over several years is better than analyzing them over one year.
ROE should be used in conjunction with other financial metrics.
Conclusion
Return on equity is one of the most valuable metrics for investors to use to evaluate a company’s success in converting shareholders’ capital to profits. While a high ROE indicates that a company may be of strong quality, investors should analyze the company’s factors that drive its ROE. By considering ROE as part of a comprehensive financial and industry analysis of companies, investors can find companies that can generate strong long-term returns for shareholders.