Return on Equity is one of the primary financial ratios investors use to judge a company’s operations. If I were to pick one metric that matters (OMTM) for investors looking into a company’s operational excellence, return on equity would be the that metric. It appears to be Warren Buffett’s favorite metric.
What Does Return on Equity Mean?
Return on equity = Net Income/Shareholder Equity
The shareholder equity, also known as the book value of the stock, is a measure of the shareholder capital invested in the business. Shareholder equity starts with the invested capital when the business starts, and later goes up or down by the amount of retained earnings of the company each period.
ROE, therefore, shows us how efficient the company is in generating profits for each unit of shareholder equity. High ROE is typically better, although the actual levels vary between industries.
Arguably, if the company generates an ROE that is less than the return an investor can get elsewhere, the investor has no incentive to invest in the company. In such cases, the company should either seek high ROE projects for each dollar that is reinvested in the business. If high ROE projects cannot be found, then the company should return capital back to the shareholders.
As you will see, companies have many levers to increase their ROE.
What is ROE Made Up Of?
At the simplest level, the ROE is made up of the Net Income and Shareholder Equity.
This number does indeed provide good information about the business. A 15% – 20% ROE is considered to be good, and normally if you see a company in this range, you may not think much about digging deeper.
But that would be a mistake.
You see, two companies sporting similar ROE may be vastly different businesses.
This becomes clearer when we break down the ROE into its components using the Dupont Model.
We can rewrite
Return on Equity = Net Income/ Shareholder Equity = (Net Income/Sales) x (Sales/Assets) x (Assets/Shareholder Equity)
or in other words,
ROE = Profit Margin x Asset Turnover x Financial Leverage
Now it becomes clearer that a high return to equity can arise from either
- More profitable products or services,
- More efficient asset utilization to generate sales, or,
- More debt in the capital structure (implying less use of equity)
In the next section let’s expand on this a bit more to see what kinds of insights we can derive them
What Does High or Low ROE Tell Us About the Company?
Suppose you are looking at a business with a high Return on Equity.
This is possible if the company is in a business to sell luxury goods (high profit margins). A company like Tiffany’s may sell products in low volumes, but each unit sold is highly profitable. As you can guess, strong brand names fall in this space.
It is also possible if the company operates with very little profit margin, but moves a lot of volume very quickly. For example, Walmart operates with very thin margin, but turns over a lot of product very quickly per unit of shelf space. Walmart has a very high asset turnover compared to many other retailers. This is why Walmart can have a high ROE despite operating in a low margin business. This is where commodity businesses can generate high ROE by making efficient use of their assets.
Finally, none of this can be true, but a company may still have a high ROE because it has low E (equity). This means the company is highly leveraged with a lot of debt. While debt is not automatically bad, you need to make sure that a high ROE company is not carrying unsustainable debt load. Enron anyone?
On the other hand if you find a company that has a low to middling profit margin, and average asset turnover for the industry, but carries very little debt, a judicious amount of additional debt will invariable improve the return on equity and benefit the shareholders significantly.
Where is the Moat?
As value investors we consider wide moat companies as worthy investments, even if we pay up a little bit more. This is because a wide moat implies a sustainable competitive advantage, that will protect a companies dominance in the market for years to come.
But where does the moat come from? Is there a metric, or a number, we can use that shows us the moat-iness of a business?
I suggest the Return on Equity is one such metric, but with a caveat.
From the universe of the high ROE companies, you need to remove the companies that achieve this distinction by loading up on debt to an unsustainable level.
This will leave us with companies that generate their sustainable competitive advantage from either their brand strength, or their operational excellence.
Oh, and One Last Thing …
You know the story … private equity meets an under appreciated gem … private equity thinks with a little polish this gem could be worth more … private equity has no clue how to improve profits or operations … private equity remembers this one weird trick to juice up the ROE … private equity loads up on debt and sells the now high ROE company to the unsuspecting suckers investors.
Don’t be that sucker.