Assets are financed in part by liabilities and in part by equity. Value investors are not interested to know how much return the company gets from its total investment (debt plus equity), but rather they are interested in the return that the company generates on their shareholdings. To measure how the stockholders are fared during the year, return on equity (ROE) is calculated.
Return on assets (ROA) takes into consideration the return that the company generates from its total assets which is financed by both debt and equity.
Return on equity (ROE) measures how successful a company is by using shareholders capital to produce profit. In simpler terms, ROE is known as net profit earned by the company on its equity share capital or relates the net earnings generated by a company to the assets invested by its shareholders.
This is the most commonly used ratio by value investors for measuring return on the owner’s investment in relation to net earnings.
Company’s success can be assessed from following three activities:
Success from these activities can be measured by looking at the components of return of equity (ROE).
Formula to calculate ROE or return on equity
Here is the basic formula to calculate return on equity (ROE):
Net income or profit available for common stockholders / Shareholders equity
As an analyst, you need to analyse return on equity by breaking it down to a function of different ratios so that the impact of leverage, profit margin and turnover on shareholders return can be analysed.
To break down ROE from the above three activities, let’s multiply total assets / total assets to the above equation.
Return on equity = (net income / total assets) * (total assets / shareholders equity)
ROE = Return on assets * Financial leverage
Both assets turnover and financial leverage measure investing success and financing activities of the company. Return on assets tells us how much profit a company is able to generate for assets invested. Whereas financial leverage indicates, how much money the firm has deployed for each amount of money invested by equity shareholders.
The second equation can be decomposed as a product of profit margin, assets turnover and financial leverage as shown below:
= (Net income/sales) X (sales/total assets) X (total assets / shareholders equity)
= net profit margin X assets turnover X financial leverage
Profit margin reflects operating margin or operating success of a company. It’s also known as return on sales. Net profit margin indicates how much money a company is able to keep for each amount of sales it makes during the year.
Assets turnover in this equation, indicates how much money it’s able to generate for each amount of its assets. It reflects the investing success of a company.
Financial leverage determines the success of financing activities of a company. It’s also known as equity multiplier. Financial leverage occurs when the capital structure of the company contains obligations with fixed interest rates. It captures how a company finances its assets.
Company’s return on equity is affected by following factors:
- How well manager employs its assets,
- and how big company’s asset size is in comparison to equity capital, and
- Company’s profit margin
Value investors will always look for opportunities where in the long run, the company can generate ROEs more than its cost of capital. In all these cases, you will find the company’s book value always less than the market price i.e. high price to book ratio.
Please note, this ratio will not tell you whether the return is due to high profit margins or due to effective use of assets or due to financial leverage. As a value investor you need to analyse ROE. For instance, investors can not know the impact of a company’s debt on its future profitability from the return on equity ratio.
To increase Return on equity, management can do followings;
- Improve profitability as return on equity can decrease with lower profit margin. This means, management has to squeeze profit out of each dollar of sales.
- Manage expenses.
- Use the company’s assets more effectively to generate sales.
- Implement a better capital structure to use debt more effectively. For instance if a company has obtained funds and is getting a return higher than the interest cost, then it will make a positive contribution to the return on equity.
- Manage inventory effectively as an increase in it can reduce the return on equity.
Do not get confused with Return on assets (ROA).
ROA relates a company’s earnings before interest and tax (EBIT) to all the assets used in a company to generate profit. It measures management’s success in using all the assets of the company. However to calculate return on equity, you need to take net earnings in the numerator and equity capital in the denominator.