Return on Equity and Return on Capital

Identify well managed profitable companies!

Return on equity (ROE), return on capital (ROC) and return on funds employed (ROFE) are measures of how well a company is being managed.

They are measures of company profitability as distinct from profit, and are sometimes referred to as profitability ratios.

A well-managed company can be expected to provide an enhanced return if the business is fundamentally sound.

I concentrate on return on equity rather than the other two. This is because as a shareholder, I own part of the equity (shareholders equity), and I want a good return on it.

Return on capital (ROC) and ROFE bring debt into the equation which confuses the two things. Debt can be better considered by looking at other measures.


Calculating ROE

ROE is calculated by dividing the net (tax-paid) profit by the sum of shareholders' 'ordinary' equity and expressing this as a percentage.

ROC and ROFE include the combined return on both earnings and borrowings. ROC and ROFE would be expected to be less than ROE as borrowings involve interest payments.

ROC and ROFE indicate how well the company is making use of its borrowings.


Significance of ROE

I look for ROE and ROC exceeding 15% since it is these returns that add to shareholder value - which is what value investing is about.

Low debt and a significant re-investment of earnings ensures that the company can magnify its performance over time.

Shareholders can’t expect high returns in the long term if the ROE and ROC are low.

Companies with low ROE should be handing back profits to shareholders by invoking high payout ratios since retaining earnings to magnify poor performance will destroy value.

Of course, the overall return I get will also depend on the price at which I buy the stock and how long I hold it for.

Return on capital is used in Joel Greenblatt's magic formula investing approach. He has demonstrated by back testing that by choosing stocks with a combination of high return on capital and high earnings yield (low price earnings ratio), a high return can be achieved if invested for the longer term.

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Time is the friend of well-managed businesses!

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Reasons for ROE Reduction

A company may cause its ROE to be lowered because it has recently undertaken a large acquisition and funded the purchase by issuing more shares.

The increase in the number of shares has the effect of lowering the ROE and ROC, one hopes in the short term. The benefits of these acquisitions may not yet had the chance to flow through to earnings.

So I check the background and announcements that companies make in order to have a better understanding of what they are doing and what effect this may have, if any, on the return on equity.

Their performance in quickly enhancing returns from any previous acquisitions may provide some confidence as to their ability to add value from recent take-overs.

Keeping an eye on how a company's ROE grows or fades over a number of years provides an indication on whether the company is adding value or running out of steam.

To me, an ongoing high ROE is also an indication of the strength of the company's economic moat or competitiveness. It is doing something right to ward off competition.

Young companies that are growing quickly may exhibit large returns on equity which can't realistically be sustained over time.

So a drop in ROE from large values is not necessarily a bad thing - but if a return on equity drops below 15%, I start getting concerned.


Rises in ROE

On the other hand, if the ROE of a company suddenly jumps, it could be due to the fact that the company has borrowed money to buy back shares. This effectively reduces the shareholders equity. And because shareholders equity is on the denominator (bottom line) of the ROE ratio, the value of the ratio jumps.

This might make the company be seen in a better position with respect to its return on equity, but it also increases risk as the debt to equity ratio has risen as well.

So the moral of the story is to not consider ROE in isolation, but take debt into account as well as other considerations.


To Conclude

When searching for wonderful businesses using a stock screener, return on equity greater than 15% is one of the important financial measures I filter on.

Since this is the measure that determines profitability, as distinct from profit, and reflects the ongoing competitiveness of the company.

But I don't rely on ROE without considering other metrics such as the debt to equity ratio.

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