How Return on Equity Can Help Uncover Profitable Stocks

Investing in companies that generate profits more efficiently than their rivals can be very profitable for portfolios. Return on equity (ROE) can help investors distinguish between companies that are profit creators and those that are profit burners. On the other hand, ROE might not necessarily tell the whole story about a company and must be used carefully.

By measuring the earnings a company can generate from assets, ROE offers a gauge of profit-generating efficiency. ROE helps investors determine whether a company is a lean, profit machine or an inefficient operator.

Firms that do a good job of milking profit from their operations typically have a competitive advantage—a feature that normally translates into superior returns for investors. The relationship between the company's profit and the investor's return makes ROE a particularly valuable metric to examine.

To find companies with a competitive advantage, investors can use five-year averages of the ROE of companies within the same industry.

A company's ROE ratio is calculated by dividing the company's net income by its shareholders' equity, or book value. The formula is:

$\textit{Return on equity = }\dfrac{\textit{Net income}}{\textit{Shareholders' equity}}$Return on equity = Shareholders’ equityNet income​

You can find net income on the income statement, but you can also take the sum of the last four quarters worth of earnings. Shareholders' equity, meanwhile, is located on the balance sheet and is simply the difference between total assets and total liabilities. Shareholders' equity represents the tangible assets that have been produced by the business. Both net income and shareholders' equity should cover the same period of time.

ROE offers a useful signal of financial success since it might indicate whether the company is earning profits without pouring new equity capital into the business. A steadily increasing ROE is a hint that management is giving shareholders more for their money, which is represented by shareholders' equity. Simply put, ROE indicates how well management is using investors' capital.

It turns out, however, that a company cannot grow earnings faster than its current ROE without raising additional cash. That is, a firm that now has a 15% ROE cannot increase its earnings faster than 15% annually without borrowing funds or selling more shares. However, raising funds comes at a cost. Servicing additional debt cuts into net income, and selling more shares shrinks earnings per share by increasing the total number of shares outstanding.

So ROE is, in effect, a speed limit on a firm's growth rate, which is why money managers rely on it to gauge growth potential. In fact, many specify 15% as their minimum acceptable ROE when evaluating investment candidates.

ROE is not an absolute indicator of investment value. After all, the ratio gets a big boost whenever the value of shareholders' equity, the denominator, goes down.

If, for instance, a company takes a large write-down, the reduction in income (ROE's numerator) occurs only in the year that the expense is charged. That write-down, therefore, makes a more significant dent in shareholders' equity (the denominator) in the following years, causing an overall rise in the ROE without any improvement in the company's operations.

Having a similar effect as write-downs, share buybacks also normally depress shareholders' equity proportionately far more than they depress earnings. As a result, buybacks also give an artificial boost to ROE.

Moreover, a high ROE doesn't tell you if a company has excessive debt and is raising more of its funds through borrowing rather than issuing shares. Remember, shareholders' equity is assets less liabilities, which represent what the firm owes, including its long- and short-term debt. So, the more debt a company has, the less equity it has. And the less equity a company has, the higher its ROE ratio will be.

Suppose that two firms have the same amount of assets ($1,000) and the same net income ($120) but different levels of debt: Firm A has $500 in debt and therefore $500 in shareholders' equity ($1,000 - $500), while Firm B has $200 in debt and $800 in shareholders' equity ($1,000 - $200). Firm A shows an ROE of 24% ($120/$500) while Firm B, with less debt, shows an ROE of 15% ($120/$800). As ROE equals net income divided by the equity figure, Firm A, the higher-debt firm, shows the highest return on equity.

Firm A looks as though it has higher profitability when it really just has more demanding obligations to its creditors. Its higher ROE may, therefore, be simply a mask of future problems. For a more transparent view that helps you see through this mask, make sure you also examine the company's return on invested capital (ROIC), which reveals the extent to which debt drives returns.

Another pitfall of ROE concerns the way in which intangible assets are excluded from shareholders' equity. For the sake of being conservative, the accounting profession generally omits a company's possession of things like trademarks, brand names, and patents from asset and equity-based calculations. As a result, shareholders' equity often gets understated in relation to its value, and, in turn, ROE calculations can be misleading.

A company with no assets other than a trademark is an extreme example of a situation in which accounting's exclusion of intangibles would distort ROE. After adjusting for intangibles, the company would be left with no assets and probably no shareholder equity base. ROE measured this way would be astronomical but would offer little guidance for investors looking to gauge earnings efficiency.

Let's face it—no single metric can provide a perfect tool for examining fundamentals. But contrasting the five-year average ROEs within a specific industrial sector does highlight companies with a competitive advantage and knack for delivering shareholder value.

Think of ROE as a handy tool for identifying industry leaders. A high ROE can signal unrecognized value potential, so long as you know where the ratio's numbers are coming from.