Understanding ROE (Part 1)

Return on Equity (ROE) is a metric I have long since understood to be an important part of stock analysis. Outlier cases are what bring me to write about it today and I will get to those at the end of the mini-series. I will start by defining ROE and discussing why it’s worth studying.

ROE is a financial ratio measuring a company’s profitability (efficiency) by calculating net income per dollar of shareholders’ equity. This breaks down to the triple product of net profit margin, asset turnover ratio, and financial leverage:

Net Income * 100       Sales              Assets                   Net Income * 100
----------------  *  ---------  *  ----------------------   =   ----------------------  (1)
     Sales             Assets       Shareholders' Equity         Shareholders' Equity

Another way to calculate ROE = earnings per share / book value per share.

That ends the heavy math for today’s post.

Reasons to analyze ROE include:

• To show how effectively management uses investors’ money to produce earnings: a high ROE often suggests competitive advantage (per Investopedia).
• To compare profitability between companies within the same industry (per TD Bank).
• To indicate potential growth as companies with consistently high ROE are able to reinvest profits for growth rather than having to take on more debt or issue more shares.
• To evaluate management quality as consistently high ROE is a sign of strong, efficient management (per SmartAsset).

When starting with an isolated look at ROE, over 15% is good and over 20% is exceptional. Look closer if it seems too good to be true. Also look closer if it’s [hugely] negative especially if profitability for the company seems acceptable.

After looking in isolation, evaluate ROE against peer and industry averages for more complete context. Net or pretax profit margin is another metric to compare with peers and the industry: comparatively higher is better.

As debt-to-equity can artificially inflate ROE, make sure to look at that too.

I will end here to keep my promise regarding the heavy math. Prepare for a longer post next time.