ROE: The Key to Comparing Company Performance

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What is Return on Equity (ROE)?

Return on equity (ROE) is a key financial ratio used to measure a company's performance and is defined as the amount of net income generated relative to total shareholder equity. ROE is often used by analysts and investors to compare a company’s profitability and financial stability relative to other companies in the same industry. 

It is calculated by taking the company’s net income for the past year, divided by its total shareholders’ equity (shareholders’ equity = total assets – total liabilities).

ROE is important in evaluating a company’s financial performance because it gives investors and analysts an indication of how well the company is using its capital and whether or not it is generating enough returns to justify its investors’ investments. 

A high ROE indicates that a company is generating more net income with less invested capital, while a low ROE can signify that a company needs to improve its operational efficiency.

ROE also plays an important role in financial ratio analysis. A comparison of a company's ROE to those of other companies within its industry can provide insight into how well that company is performing in terms of generating profits from its investments. 

Analysts can also use ROE to measure the effectiveness of management, identify potential issues with the company's operations, and determine if the company should invest in new projects or expand existing ones.

How to Calculate ROE?

There are two ways to calculate ROE: the basic formula and the extended formula.

The basic formula

The basic formula for ROE is:

ROE = Net Income / Shareholders' Equity

Net income is the amount of income that a company earns after deducting all expenses, taxes, and dividends. It can be found on the income statement of a company.

Shareholders' equity is the amount of money that belongs to the shareholders after subtracting all liabilities from all assets. It can be found on the balance sheet of a company.

For example, suppose Company A has a net income of $10 million and a shareholders' equity of $50 million. Then, its ROE is:

ROE = 10 / 50 = 0.2 or 20%

This means that Company A earns $0.2 of net income for every dollar of shareholders' equity.

The extended formula

The extended formula for ROE is:

ROE = Net Profit Margin x Asset Turnover x Equity Multiplier

where:

• Net profit margin is the ratio of net income to revenue. It measures how much of each dollar of revenue is left as net income after paying all expenses.
• Asset turnover is the ratio of revenue to total assets. It measures how efficiently a company uses its assets to generate revenue.
• Equity multiplier is the ratio of total assets to shareholders' equity. It measures how much leverage a company uses to finance its assets.

The extended formula breaks down ROE into three components that reflect different aspects of a company's performance: operating efficiency, asset use efficiency, and financial leverage.

For example, suppose Company B has a net income of $15 million, revenue of $100 million, total assets of $200 million, and shareholders' equity of $100 million. Then, its ROE can be calculated as:


Net profit margin = 15 / 100 = 0.15 or 15%


Asset turnover = 100 / 200 = 0.5 or 50%


Equity multiplier = 200 / 100 = 2


ROE = 0.15 x 0.5 x 2 = 0.15 or 15%


This means that Company B earns $0.15 of net income for every dollar of shareholders' equity.

Comparing ROE Across Companies

However, it's not always easy to compare ROE across different organizations. The capital structure, growth rate, dividend policy, accounting procedures, and industry features of a company are a few variables that can influence its ROE. 

Consequently, before utilizing ROE as the foundation for investment decisions, it's critical to grasp its drivers and constraints.

Financial leverage is one of a company's key factors in determining ROE. When debt is used to finance assets, this is called financial leverage. Financial leverage ratio is higher for a corporation with more debt than equity. 

A company's ROE can be increased by using financial leverage, which raises net income in comparison to equity. The earnings and cash flows of the company are likewise subject to greater risk and volatility as a result.

Return on assets (ROA) is another factor that influences ROE. The return on assets (ROA) indicates how effectively a business turns its total assets into earnings. You may figure it out by dividing net income by the average total assets. A company is more effective at converting assets into income if its ROA is higher. Profit margin and asset turnover are the remaining two parts of ROA. 

The ratio of net income to sales is known as the profit margin, while the ratio of sales to total assets is known as the asset turnover. The ROE and ROA of a corporation can both rise as a result of increasing profit margins or asset turnover.

One of the limitations of ROE is that it does not account for the growth rate of a company. Compared to a company with a lower ROE but a higher growth rate, a company with a high ROE but a low growth rate might not be as appealing. 

This is so that over time, a high-growth business can increase the value it provides to its shareholders by reinvesting its earnings at a higher rate of return. In order to keep its ROE at a certain level, a low-growth corporation could have to pay dividends or repurchase its own stock.

Another limitation of ROE is that it can be affected by accounting methods and industry characteristics. The comparison of ROE across companies may be skewed by the varying net income and equity figures that different accounting systems can produce for the same business. 

For instance, some businesses could employ more aggressive depreciation policies or inventory valuation techniques than others, which can have a negative impact on their net income, equity, and ROE.

Similar to how different industries may differ in their capital intensity, profitability, and growth prospects, these factors can affect the levels of ROE in those industries. For instance, some industries might need more working capital or fixed assets than others, which could raise their overall assets and equity and reduce their ROE.

Because of this, it's crucial to take into account and account for all potential influences when comparing ROE between different organizations. The DuPont analysis, for instance, can be used to break down the ROE into its component parts and pinpoint the reasons behind variations in ROE between businesses. In addition to the examination of ROE, other ratios can be used to gauge a company's value creation, such as return on invested capital (ROIC) or economic value added (EVA).

Case Study: Comparing ROE Across Companies in the Same Industry

How, though, can ROE be used to contrast businesses operating in the same sector? Should we take into account additional criteria in addition to ROE, or is it sufficient to just look at ROE? Using Walmart, Target, and Costco as our case studies, we will examine these issues in more detail.

ROE of Walmart, Target, and Costco

According to their latest annual reports, the ROE of Walmart, Target, and Costco for the fiscal year 2022 were as follows:

• Walmart: 20.5%
• Target: 29.8%
• Costco: 22.4%

These figures can lead us to believe that Target is the most successful and effective business of the three due to its high ROE. If we neglect to include other elements that influence ROE, this finding could be deceptive.

Factors that Affect ROE

ROE can be affected by several factors, such as:

• Net profit margin: It analyzes how much of every dollar of revenue remains as a profit after all costs have been paid. This ratio is known as net income to revenue. When all else is equal, a larger net profit margin results in a higher ROE.
• Asset turnover: This measure of how effectively a business uses its assets to create income is the ratio of revenue to total assets. If everything else is equal, a higher asset turnover will result in a higher ROE.
• Equity multiplier: It gauges how much leverage a company employs to fund its assets and is expressed as the ratio of total assets to shareholders' equity. If all else is equal, a greater equity multiplier will result in a higher ROE.

We can use the following formula to decompose ROE into these three factors:

ROE = Net Profit Margin x Asset Turnover x Equity Multiplier

Using this formula, we can calculate the net profit margin, asset turnover, and equity multiplier of Walmart, Target, and Costco for the fiscal year 2022:

• Walmart: 20.5% = 3.1% x 2.2 x 3.0
• Target: 29.8% = 6.3% x 1.9 x 2.5
• Costco: 22.4% = 2.4% x 3.6 x 2.6

Analysis of ROE Components

By looking at the components of ROE, we can gain more insights into how each company performs compared to its peers.

• Net profit margin: Target has the strongest operating efficiency and cost control among the three businesses, as seen by its largest net profit margin. Costco has the lowest net profit margin, meaning that the business runs on very narrow margins and depends heavily on high sales volume to make money.
• Asset turnover: Costco has the best asset usage and inventory management among the three businesses since it has the biggest asset turnover. Walmart has the lowest asset turnover, which indicates that a lot of its assets are lying around or being used inefficiently.
• Equity multiplier: Walmart employs more debt than equity to finance its assets since it has the biggest equity multiplier of the three businesses. Its financial risk rises as a result, but its returns on equity are also amplified. Costco has the lowest equity multiplier, which indicates that it finances its assets mostly through stock rather than debt. Although this decreases its financial risk, it also results in poorer returns on equity.

Best Practices for Using ROE to Compare Companies

So how can you use ROE effectively to compare companies? Here are some best practices to keep in mind:

• Combine ROE with other metrics and ratios. ROE is not a reliable predictor of a company's worth or quality on its own. It must be combined with other metrics like debt-to-equity ratio, valuation multiples, profit margin, revenue growth, and growth in earnings, revenues, and profit margin. These measurements can give a clearer view of the financial health and growth prospects of a company.
• Compare ROE across the same sector or industry. Capital intensity and profitability vary across various industries and sectors. For instance, because they have fewer capital requirements and larger profit margins than utility businesses, technology companies typically have higher ROEs. As a result, comparing ROE between businesses in the same industry or sector is more insightful than doing so between different ones.
• Compare ROE over time. Changes in net income, shareholders' equity, or both might affect ROE year over year. The ROE for a single year could not be indicative of a company's long-term success or trend. In order to find consistency or growth over time, it is, therefore, preferable to compare ROE over a number of years or quarters. A business that can sustain or grow its ROE over time may have a solid growth strategy or a lasting competitive advantage.
• Adjust ROE for non-recurring items. Sometimes one-time or irregular factors, such as asset sales, write-offs, restructuring costs, tax advantages, or litigation settlements, can have an impact on a company's net income or shareholders' equity. Several factors might skew a company's real profitability or capital structure, making its ROE inaccurate or unrelatable. As a result, it is wise to adjust ROE for these one-time expenses and utilize the adjusted ROE for comparison.
• Understand the drivers of ROE. Three elements can be separated out of ROE: profit margin, asset turnover, and financial leverage. The amount of each dollar of revenue that is transformed into net income is known as the profit margin. Asset turnover gauges how effectively a business generates revenue from its assets. Financial leverage quantifies the ratio of a company's debt to equity. You can calculate a company's ROE by adding these three elements together.

FAQ

Return on Equity, or ROE, is a metric that expresses how well a business turns a company's equity into profits. Net income is divided by shareholders' equity to arrive at this figure. A greater ROE indicates more profitability and efficiency in the company's use of equity capital.

ROE can be broken down into three components using the DuPont analysis, which multiplies the net profit margin, the asset turnover, and the equity multiplier. The asset turnover metric gauges how well the business uses its assets to create sales, the equity multiplier indicates how much leverage the business employs to finance its assets, and the net profit margin indicates how much of each dollar of sales is left as net income.

The business cycle, the capital structure, the dividend policy, the industry or sector in which the firm works, and the accounting practices are a few variables that can impact ROE. ROE may vary among companies or sectors due to variations in profitability, risk, and growth potential. The business cycle can also have an impact on ROE since, depending on the state of the economy, companies may see increases in or decreases in earnings. 

The capital structure can also impact return on equity (ROE); utilizing more debt raises the equity multiplier but also raises interest costs and financial risk. In the same way that various techniques of depreciation, inventory value, or revenue recognition can affect net income and shareholders' equity, so too can accounting policies impact return on equity.