Key to making money with shares. Lesson 10. Return on equity (ROE)

30-04-2021

Definition

Return on Equity or ROE is a metric of financial performance calculated as net income divided by the value of its total shareholders’ equity and expressed as a percentage.

This indicator is crucial for investors since it helps to gain an insight into how well the invested shareholders’ equity has been used and whether the assets actually generate proper returns. ROE reflects the efficiency of using the portion of equity––or assets––that belongs to the company owners.

ROE has two key components:

1. It compares the figures of the income statement, and

2. losses to the net income relative to shareholders’ equity.

In other words, it measures how much profit is made for each dollar of shareholders’ equity.

Calculation Formula

ROE = Net Income / Shareholders’ Equity


ROE ratio: Calculation Formula 1

ROE provides a simple and straightforward metric for the evaluation of returns. By comparing the company's ROE to the industry-average figures, you can get an idea of your competitive advantage. On top of that, ROE allows seeing whether the shareholders’ equity is used well by the company's management team in order to grow the business.

Meaning behind ROE

A stable and steadily increasing return on equity means that the company is creating solid shareholder value. It knows how to reinvest its profits efficiently and boost performance. In contrast, when ROE figures are declining, this may imply that the company is adopting poor decisions as far as capital reinvestment goes.

Relevance

ROE helps investors understand the return they get by investing in a particular company. The company, in turn, applies this metric to evaluate the efficiency of the shareholders’ equity usage. To be able to meet the needs of investors, the company needs to put its best foot forward to achieve a higher ROE.

Application

ROE alone does not mean much unless you analyze it along with historical data and industry-average figures. In order to get a clear picture of the company’s performance and ensure proper evaluation, we need to use other multiples. E.g. Cyclical industries tend to generate bigger ROE.

In addition, it is recommended to compare the company's return on equity to its shareholders’ equity. If the return on equity exceeds the cost of equity, it means that the company has added value. The stocks of a company with an ROE of 20% will typically be worth twice as much as the stocks of the company with an ROE of 10% under otherwise equal conditions.


Practice. Booking Holdings Inc. (BKNG)

Let’s use several methods to calculate its ROE for the quarter ended in September 2020

1. Net income for trailing twelve months (TTM) for the quarter ended in September 2020.

ROE ratio: Figure 1


Net Income (Sep 2020) = $1,171 (Dec 19) − $699 (Mar 20) + $122 (Jun 20) + $801(Sep 20) = $1,395

2. There are several ways to calculate shareholders’ equity or you can take a simpler route and look it up in the relevant item on the balance sheet.

ROE ratio: Figure 2


Total Shareholders’ Equity = Total Assets − Total Liabilities = $22,145 − $17,232 = $4,913

ROE ratio: Figure 3

3. Let’s calculate Booking’s ROE for the quarter ended in September 2020.


ROE = Net income / Total Shareholder’s Equity = 1,395 / 4,913 = 0.2839 = 28.39%

4. Drivers of ROE. The ROE formula here is net income divided by shareholders’ equity. However, we can break it down into additional components. By taking a look at the figure below, you will see that the ROE calculation formula consists of the return on assets (ROA) and the leverage.

ROE ratio: Figure 4

Let’s take a closer look at it.


Net Income / Equity = (Net Income / Total Assets) * (Total Assets / Equity) = (1,395 / 22,145) * (22,145 / 4,913) = 0.2839 = 28.39%

5. DuPont Formula

DuPont formula breaks down ROE into three main components. Each one can come in handy when examining the company’s returns. Basically, ROE is equal to the net income multiplied by total assets multiplied by the leverage.

ROE ratio: Figure 5

An increase in the net profit margin implies that the company is managing its operating and financial expenses really well, which, in turn, will drive up ROE. The growing asset turnover means that the shareholders’ equity is being used efficiently. In other words, the company generates more sales for each dollar of owned assets. When there is an increase in financial leverage, the company can use borrowed funds to boost profits.

To illustrate this, we are going to apply the DuPont 3-step method.

To do this, we shall take the figures of the last twelve months revenues (TTM) for the period ended in September 2020

(see here)


Net Sales = $3,339 (Dec 2019) + $2,228 (Mar 2020) + $630 (Jun 2020) + $2,640 (Sep 2020) = $8,897


ROE = (Net Income / Net Sales) * (Net Sales / Total Assets) * (Total Assets / Equity) = ($1,395 / $8,897) * ($8,897 / $22,145) * ($22,145 / $4,913) = 28.39%

It stands to mention that there are certain challenges associated with DuPont analysis:

1. Too many figures involved. Just one mistake in calculation can lead to inaccurate interpretation. Plus, the information source has to be very reliable.

2. Seasonal factors must be taken into consideration when performing DuPont analysis. In most cases, this can be quite problematic.

6. We have been witnessing a gradual decline in Booking Holding’s return on equity since the end of 2019, i.e. each dollar of shareholders’ equity generated $0.28 in net profit as compared to $0.80 at the end of 2019.

ROE ratio: Figure 6

7. As compared to competitors, Booking Holding’s ROE obviously takes the upper hand. The highest ROE over the course of the last 13 years was 66% with the lowest being 22%. The median figure is 34%.

ROE ratio: Figure 7

Drawbacks

  • High ROE is not necessarily a good sign. Unreasonably high ROE figures may be linked to a low percent of equity/high percent of borrowed funds which will have a negative impact on financial stability.
  • Debt financing can be used to increase ROE. With that said, we must not forget that excessive leverage can lead to increased interest payments and risks. The greatest value is created when the optimal capital structure is ensured. This allows to balance the risks and benefits of leverage.
  • The exclusion of intangible assets––goodwill, trademarks, etc.––from shareholders’ equity when calculating ROE can result in distortion of figures and complicate the correlation with other companies that included intangible assets.
  • The company may write off assets and buy back the shares in order to artificially inflate ROE by decreasing the total shareholders’ equity i.e. the denominator.
  • ROE is relevant in cases where the company has its own equity (positive net assets).
  • For the sake of clarity, you need to have your data straight. E.g. Equity at the beginning and at the end of the period, or weighted average, usage of EBIT/EBITDA instead of net profit, etc.

Let’s sum things up

ROE is a go-to indicator for any shareholder and investor as it helps to understand the returns their capital is generating. With that said, if you wish to learn what is behind ROE, you have to apply the DuPont equation. That way you will be able to identify the actual culprit and find out how the business addressed it.

Based on DuPont analysis, we compare three separate ratios in order to establish whether it makes sense to invest in a particular company.


Key to making money with shares. Lesson 9. ROA. Facebook     Key to making money with shares. Lesson 11. ROI


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