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Why Return on Equity Is Important To Value Investors

Return on Equity (ROE) is one of the financial ratios under Profitability. It calculates how many dollars of profit a company generates with each dollar of shareholders’ equity. Sometimes, ROE is also known as “return on net worth.” 

 

Formula of Return of Equity

ROE = Net Income/Shareholders’ Equity

 

For example, Company A generated $150k in net income this year. If the value of her shareholders’ equity is $1 million this year, then

ROE = $150,000 / $1,000,000 = 0.15 or 15%

 

Why Return on Equity Is Important?

Return of Equity is one of the more important financial ratios that value investors like us will be keen to know. ROE is certainly a good measure of both profitability and efficiency. A company with a rising ROE over the years indicate its better ability to earn increasing profits with the existing capital. This shows that the management of the company is able to efficiently utilising the shareholders’ capital to maximise the returns for the company. On the contrary, a company with a falling ROE over the years may be a bad sign to investors.

 

What happen if the value of the shareholders’ equity goes down?

This could be in a scenario where there may be write-downs and share buyback or the company has high debt. Either of such scenario will boost up the ROE artificially. Therefore, it is important to be mindful that it is good to co-check a company’s debt level and any history of write down or share buyback before concluding it is a good ROE. If net income has increased over the years, a high ROE will be more attractive to value investors.

For the same reason, it is a fairer comparison of ROE of the companies within the same industry than in different industry. Companies in different industries may have different levels of debt and capital.

If you wish to know more about the cross checking of ROE with other financial ratios, invest your time to attend our 3 days value investing bootcamp. We will have more time to guide and train our students a systematic approach towards value investing.

 

Check out other profitability ratios.

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