ROE or ‘return on investment’ is one method for calculating a company’s performance. It is calculated by dividing a company’s net income by shareholder’s equity, during a business year. Share holder’s equity is calculated by subtracting the company’s total liabilities from total assets.
While some investors constantly watch the price movements of a company’s stock, looking at the company’s return on equity, it can give you some indication of the quality of business. Famed investor Warren Buffett, is said to use ROE as one of his key factors for deciding to invest in a company. He is said to target companies with an average of at least 15 per cent ROE, over a ten year period.
A company with a higher ROE is obviously more attractive, but you need to look a company’s historical performance, and also compare it to other companies and companies in the same industry. Companies can artificially raise their ROE by increasing long term debt and using the money to buy back company shares. So a company can appear stronger by having a high ROE, but it will also have higher long term debt, and then it will need to make costly interest payments. So it is important to not only calculate ROE, but investigate the reasons why the figure might be high.
Forbes also points out another weakness of relying on ROE:
“A company with comparatively low incremental costs for selling additional products that have short lifespans will typically have higher ROE ratios than a company with comparatively high incremental costs for selling additional products that have longer lifespans.”
Although the article does come to the conclusion that companies with a very low ROE, say less than 5 percent, are a good indication of very poor performance. Research companies typically have ROE as investment in research is regarded as an expense, rather than an asset.
Other key investment metrics include Return on Capital (ROC) and Return on Investment (ROI). ROC is basically the same as ROE, but includes the company’s debt, in the form of loans and bonds. ROI is the calculation of a return on investment.
Companies can of course legitimately increase their ROE in a number of ways. One way is to increase the company’s sales turnover. A company’s sales turnover is the ratio of sales to total assets. They can do this by utilizing their assets more efficiently, such as inventory and receivables. Another way is to increase prices faster than increasing costs.
The benefits for a company with a high ROE include:
– The company has sufficient funds to invest back into the business, without having to seek further investment from its investors.
– The company does not need to borrow more money, which is always a healthy sign in business.
The investing website fool.com.au highlighted four Australian companies with a high ROE in January 2014. They include Telstra, ROE 40%, BHP Billiton, ROE 16.7%, Rio Tinto, ROE- 19.8% and CSL Limited with a staggering ROE of 40.4%.
While Return on Equity is an essential tool for analysing the investment potential of a company, used by investor geniuses like Warren Buffett, it cannot be used in isolation. You also need to look at the ROE over a number of years. Management can artificially inflate the figure, so if a company has a high ROE, you need to also understand why. It is a useful tool for comparing the performance of companies in a specific industry, such as mining.