What is Return on Equity (ROE)

ROE measures a company’s returns on its shareholders’ investments in the same manner. ROE is a company’s annual net income divided by its shareholders equity.

ROE = net income/shareholder’s equity

ROE is widely reported, and many money managers rely on it as a key gauge of a company’s profitability.

In the example, I suggested a situation where a $100,000 investment (equity) yields a $10,000, or 10 percent annual return on your equity. Let’s postulate that you could earn a 10 percent return on any additional cash you put into the business. Further assume that you are willing to invest your profits into growing the business, but you’re not willing to put in additional cash or borrow more money.

Based on those assumptions, you’d invest your first year’s 10 percent return ($10,000) on your equity back into the business, so the second year, the company would earn 10 percent on $110,000 equity, 10 percent more than the first year’s $100,000 equity, and so on.

Your 10 percent return on equity defined the maximum annual growth that your company can achieve given the assumptions. In the same way, ROE determines the maximum achievable growth for a corporation, making similar assumptions. That is, that the company doesn't raise additional cash by borrowing or selling more stock, and that its profit margins remain constant.

Suppose in my hypothetical example that you had decided that you’d take $1,000 out of the business annually, but reinvest the balance of the profits in the business. In that instance, your $1,000 dividend would have to be subtracted from your ROE to determine the future growth. The term implied growth defines a corporation’s maximum achievable growth accounting for dividends paid out by the firm.

implied growth = (net income – dividends)/shareholders’ equity

Implied growth is the same as ROE if a company doesn’t pay dividends.

Assuming that it doesn’t raise additional cash, and profit margins remain constant, a non-dividend-paying firm’s ROE defines its maximum growth rate. Applying numbers to the equation, a 15 percent ROE firm that doesn’t pay dividends is limited to 15 percent long-term annual earnings growth, and less if it does pay a dividend. Of course, companies often do raise additional funds though borrowings or stock sales, and profit margins often do increase over time, especially for newer companies. But stockholders are usually better off if a company doesn't have to resort to those measures to grow. Here’s why:

Selling additional stock dilutes per-share profits. For instance, a company with one million shares outstanding, and $1 million net income earns $1 per share. However, its EPS drops to $0.67 if the company makes the same profit after selling another 500,000 shares. The math works much the same if the firm borrows instead of selling shares. For example, say the same company had borrowed $1 million at 8 percent interest a year earlier. In that instance, it would earn $920,000 ($1 million less $80,000 interest), bringing its EPS down to $0.92.

Despite this sensible reasoning, using ROE to evaluate a company’s profitability has practical limitations.

Recall that ROE is calculated by dividing net income by shareholders’ equity. Book value is another way of expressing shareholder’s equity. Book value is shareholder’s equity per share; that is, equity divided by shares outstanding.

The problem lies in the equity or book value calculation. From the name, you might conclude that book value represents the value of the company’s hard assets, give or take asset depreciation or appreciation. There is such a balance sheet figure—total assets—but it’s not the same as equity or book value.

According to accounting rules, the left-side assets column total must equal the right-side liabilities column total. Normally assets exceed liabilities, so shareholder’s equity is added to the liabilities column to make them equal, giving you the basic accounting equation:

assets = total liabilities + shareholder’s equity

or

shareholders’ equity = assets – liabilities

Some very smart money managers believe that ROE is the best profitability measure. If you fall into that camp, you can overcome the downside of ROE regarding debt by comparing the growth in book value to ROE. That is, if management is properly reinvesting ROE, the firm’s book value (shareholders equity) should be increasing at the same rate as the ROE.