ROE - Return on Equity How efficient is the management really? By Mo2

What is ROE?
ROE stands for Return on Equity. Which essentially tells us how the management of a company did with the shareholder’s money. The number is widely used to assess the strength of a company and generally a higher number is better than a lower one, since we all want higher returns right?

The formula for ROE is:

ROE = Net Income
          Shareholder’s Equity

How is it used?
ROE has to be used in context otherwise it bears little meaning. If one shoe company has a higher ROE in comparison to a bubble gum company how do you know if this is good? You can’t because the two companies operate in completely different ways.

However, if we’re talking about two bubble gum companies that make similar flavours and use similar packaging (well just pretend everything is similar) then if one company has a higher ROE then the answer is obvious as to which company is better? You have to compare the ROE of companies in the same industry.

Is it really THAT simple?
I wish I could say yes but it isn’t. If it were this simple then everyone would simply use the ROE and our efficient market friends would have more credibility. First we need to understand what shareholder equity is. Shareholder equity is what is leftover after the company pays its expenses, debt (including interest) and its preferred shareholders among other things. Once this is done, we come to the shareholder equity which can be paid out as dividends, but that’s another story.

Is this good or bad debt?
That’s the important question here. Just because a company has a high ROE doesn’t always reveal the whole picture. We need to know how much debt is being used to boost the ROE. More debt can lead to a greater ROE but are they overdoing it with the borrowing to artificially boost the ROE?

Share buybacks
When the company buys back shares it can artificially boost the ROE. This is because when companies buy back their own shares for whatever reason, they are decreasing the outstanding equity. We also need to take into consideration as to why the company is buying back their shares. Don’t just listen to what the company says actually try to understand why. 99% of the time they’re going to say it’s because they are the best investment out there. Great sales pitch, really.

 

Mo2 Thinks...
There is no clear-cut answer when it comes down to selecting a good company when you’re making an investment. The ROE is one of many figures an investor should be looking at to help them choose their investments. Simply put, the ROE tells us what kind of return the management of a company was able to create with the equity within the company. We also need to understand what kind of debt was used to obtain these returns. Even if financial statements are prepared according to generally accepted accounting principles (GAAP), there is so much that isn’t obvious.

One of the many factors is share buybacks. Most companies will say that they are buying back their own shares because they couldn’t possibly think of a better investment than themselves. While this may hold true sometimes, it may be one of the ways for them to boost their ROE.

Record ROE doesn’t mean much either if all the company invests in is government bonds. You have to go beyond the numbers and understand why these numbers are there and then decide if they are legitimate and positive.

Nevertheless, ROE is a great way to see if a company is being run efficiently. Having a positive and competitive ROE within an industry should be a must for investors. And the decision to buy a stock (if you are a fundamentalist) should be made after using other ratios and numbers to solidify your investment decision.

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If you would like to comment on this article or anything on this website, please feel free to e-mail Mo2. He can be reached at Mo2@Mo2Thinks.com. Thank you for visiting!