Return On Equity Formula For Stock Market Beginners

How can stock market beginners use the return on equity formula to start investing in quality companies?

In recent articles, I've discussed dividend investing, price to earnings ratios and net current asset value as ways for beginners to find value in the stock market. Today I'm going to discuss return on equity, or ROE for short. While dividend yield, price earnings ratios and net current asset value are great methods for value investors to find undervalued stocks, they don't necessarily uncover quality businesses - just cheap ones. But let's not get ahead of ourselves.

What Is Return On Equity?

The first thing we should do is define return on equity. In simple terms, ROE is just the rate of return a company earns on it's stockholders' funds. What it represents is the efficiency with which the management of a corporation is able to use its net assets (net assets are total assets less total liabilities). In other words, how much profit is generated from shareholder funds.

How To Calculate Return On Equity.

The return on equity formula or equation can be expressed as follows:

ROE = Net Income / Stockholders' Equity

Net Income, known in some countries as Net Profit After Tax is the total revenue of the company less all expenses including interest and tax. Stockholders' Equity can be calculated by subtracting the total liabilities from the total assets of the business. Because stockholders' equity changes over time, it's common to use average stockholders' equity in this calculation. This means you will need to take an average of the figures as of the start of the year and the end of the year.

Unlike dividend yields and price earnings ratios, ROE is not always published in the financial press. But some of the financial websites (like Yahoo Finance) do publish the figures. However, beginner stock market investors should definitely know how to calculate this financial ratio.

Advantages Of Return On Equity?

As I said at the start of this article, return on equity differs from the value investing types of financial ratios I've discussed in recent articles (P/E, dividend yield, etc) in that ROE is a useful measure of the quality of a company's business. Companies with low P/E ratios and high dividend yields are normally trading at relatively low prices and this is part of what value investors should be looking for. But this doesn't give any indication as to the quality of the company. In fact, often the stock price is cheap because the business is just an average one. That's not to say there may not be value there. I tend to think that there is value in the stock of most corporation if the price is low enough.

By using return on equity, you should be able to find good quality businesses. The theory goes that a superior business is able to achieve and maintain higher returns on its stockholders' funds. A company with a consistently high ROE probably has good quality management or operates a business in an industry with high barriers to entry or both.

Things To Consider When Using Return On Equity.

One of the things to keep an eye on, especially when first starting out in the stock market, is the level of debt. Because of the how return on equity is calculated, high levels of debt can inflate the figures. I wont go into great detail on the maths behind this, but by being more highly leveraged a company can generate higher returns for shareholders given the same level of stockholders' funds. And while these higher returns are good up to a point, you will need to make sure that the company's debt levels are not excessive. I will write more about this in a future article, but using a gearing ratio of 50% makes sense - that is stay away from stock where the gearing ration is greater than 50% if you want to maintain a conservative investment stance - even if the ROE is high.

You may also want to look at return on equity vs return on capital. Return on capital essentially uses total assets instead so it will account for debt levels. I'll write more on this in the future.

Another thing to consider is the industry in which a business operates. I noticed that Wikipedia made the point that consulting businesses which have very low capital requirements tend to have high return on equity ratios. They also note that because of the low barriers to entry they are much more susceptible to competition than companies operating in capital intensive industries. I think another thing to consider here is whether the company has some other intangible asset (think of brand name or intellectual property) which may make it's position more defensible. I'm thinking of a company like Coca Cola which I believe has relatively low capital requirements but which is in a very strong position because of both brand and intellectual property. I think the main point is to compare ROE of companies in the same or similar industries.

Return On Equity And Growth.

ROE in isolation wont necessarily identify growth companies. You will need to have a look at what a company does with its profits. If a corporation has a high rate of return on equity but it pays out all of its profits in dividends, then it's unlikely to be a growth company - that's not to say it's not a good business. But if it's paying out all of it's profits in dividends it probably doesn't have any way in which it can reinvest its profits to grow the business. This may be because it's in a mature industry, or it may be the dominant player in it's industry with no room to grow it's market share. The fact that it earns high returns on its shareholders' funds probably means its a good business - just not a growing one. At the right price, it may still make a good investment though.

If we now look at the opposite situation, where a business earns high return on its equity and pays little of its profits out as dividends, this is a candidate for a growth stock. If it can consistently reinvest profits back into the business and consistently generate a good return on this expanded equity (reinvested profits add to shareholders' equity) then this is most likely a growth stock. Companies like these tend to trade at higher multiples because of the compounding effect of having profits reinvested in the business.

But there are a couple of things to watch out for with growth stocks. A business wont stay in this high growth phase forever. At some point growth will start to slow. Markets and not infinite in size. It will reach a point where the market is saturated, or a competitor may enter the market. So look at the trend of ROE over time. A falling ROE may indicate it's nearing the end of its growth phase.

And this is the other thing to watch out for. As the stock market gets a sniff that growth is slowing, the price will normally be discounted. Stock market participants tend to be very future-focussed. They will try to anticipate when a company will go ex-growth then move on to find the next big thing. Stock market beginners need to make sure they don't pay too much for a growth stock nearing the end of its growth phase.

I've written more than I intended on this subject, so if you've made it this far - well done. There's just one more thing I wanted to mention before I finish up, so bear with me. Joel Greenblatt (I always find that name amusing - like a character out of The Hitchhikers Guide To The Galaxy - no offense intended to Joel) wrote a book called The Little Book That Beats The Market. Joel seems like a pretty smart guy and in the book he advocates using a variant of return on equity along with a kind of modified price to earnings ratio as a way of ranking stocks. I think there's a lot of merit in this idea as it brings together a measure of quality with a measure of value. I'll need to re-read Joel's work to refresh my memory, but I think that was the gist of it. I will write more about Joel Greenblatt's Magic Formula in a future article.

Well that's definitely enough now. I think this is the longest post I've written so far. Hopefully stock market investing beginners have gained a decent grounding in return on equity after that.