Assets are financed in part by liabilities and in part by equity. Value investors are not interest to know how much return the company gets from its total investment (debt plus equity), but rather they are interested in the return the company can generate on their shareholdings in the company. To measure how the stockholders are fared during the year, return on equity or ROE is calculated.
Return on equity or 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
The Basic formula to calculate ROE is:
Net income or profit available for common stockholders / Shareholders equity
As a analyst, you need to analyze 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 analyzed.
To break down ROE from above three activities, let’s multiply total assets/total assets to the above equation.
ROE = (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. Where as 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 company is able to keep for each amount of sales it makes during the year.
Assets turnover in this equation, indicates how much money its able to generate for each amount of its assets. It reflects investing success of a company.
Financial leverage determine the success of financing activities of a company. It’s also known as equity multiplier. Financial leverage occurs when 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 long run, the company can generate ROEs more than its cost of capital. In all these cases, you will find 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, investor can not know the impact of company’s debt on its future profitability from ROE.
To increase Return on equity or ROE, 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 company’s assets more effectively to generate sales.
- Implement a better capital structure to use debt more effectively. For instance if company has obtained fund and getting return higher than the interest cost, then it will make a positive contribution to the return on equity.
- Manage inventory effectively as increase in it can reduce the return on equity.
Do not get confused with Return on assets or ROA. ROA relates a company’s earnings before interest and tax (EBIT) to all the assets used in company to generate profit. It measures management’s success in using all the assets of the company. However to calculate ROE, you take net earnings in the numerator and equity capital in denominator.