Return On Equity

Return on Equity (ROE) is a great overall measure of a company's profitability because it measures the efficiency with which a company uses shareholders' equity. Think of it as measuring profits per dollar of shareholders' capital.

As a rule of thumb, firms that are consistently able to post ROEs above 20% are generating solid returns on shareholders' money, which means they are likely to have economic moats. Significantly, Return on Equity can tell us more than just the efficiency of using shareholders capital. ROE provides a direct peek into how well a firm balances - profitability, asset turnover and financial leverage - to provide decent returns on shareholders' equity.

This is because there are only three levers for boosting ROE -Net Margin, Asset Turnover and Financial Leverage. Lets see why this is so by examining the return on equity formula.

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ROE = Earnings/Shareholders' Equity

Alternatively this can also be expressed as
ROE =(Earnings/Sales)x (Sales/Assets)x (Assets/Shareholders' Equity), or

ROE = Net Margin x Asset Turnover x Financial Leverage
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So we have three levers that can boost Return on equity -net margins, asset turnover, and financial leverage. For example, a firm can have only so-so margins and modest levels of financial leverage, but it could do a great job with asset turnover (e.g. a well run discount retailer). Companies with high asset turnover are extremely efficient at extracting more rupees of revenue for each rupee invested in hard assets. A firm might have asset turns only middling, and the firm might not have much leverage, but say it has great profit margins (e.g. a luxury goods company)-that would make for decent ROEs. Finally, a firm can also boost its ROE to respectable territory by taking on good-size amounts of leverage (e.g mature firms such as Utilities).

Calculating Return on Equity

Return on Equity is simply calculated by dividing annual earnings divided by shareholders' Equity. Annual Earnings can be taken from the Consolidated Profit and Loss Statement from the firm's Annual Reports. The Shareholders Equity can be found in the Balance Sheet filed in the firm's Annual Reports. Annual Reports can usually be found at the firm's website. Shareholders Equity is simply the difference between Total Assets and Total Liabilities -the assets that the business has generated. Shareholder equity is an accounting term that represents the assets created by the retained earnings of the business and the paid-in capital of the owners.

Rough benchmarks for analysing a stock's ROE

In general, any non-financial firm that can generate consistent ROEs above 15 percent without excessive leverage is atleast worth investigating. And if you can find a company with the potential for consistent ROEs over 30%, there's a good chance you are really onto something.

Two Caveats when using ROE to analyse stocks

First, Banks always have enormous financial leverage ratios, so don't be scared off by a leverage ratio that looks high relative to a non-bank. Additionally, since banks' leverage is always so high, you want to raise the bar for financial firms - look for consistent ROEs above 18% or so.

Second caveat is about firms with ROEs that look to good to be true, because they are usually just that. ROEs above 50% or so are often meaningless because they have probably been distorted by the firm's financial structure. Firms that have been recently spun off from parent firms, companies that have bought back much of their shares, and companies that have taken massive charges of ten have very skewed ROEs because their Equity base is depressed. When you see an ROE over 50%, check to see if the company has any of these above-mentioned characteristics.