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How To Understand And Use Return On Equity (ROE)

Return on Equity (ROE) is a common financial measurement that investors use to evaluate a company. You might find it used in stock screens as one criteria. In its simplest form it is a measurement of how well a company does on earning a return on the money investors gave the company. An investor looks to earn an outsized return on his money invested compared to other options. ROE can tell you how well the company is doing in that respect.

However, it is best to use this metric not with the ‘headline’ number but each component that goes into it and how it changes over time. Also, depending on what kind of company you are investing in and what you are looking for in a return, you will want to use ROE in specific ways to evaluate the companies performance. If you are a dividend growth investor you will want to be particularly careful not to rely on the headline number as I will talk about. It is possible for ROE to be negative, zero, a big number and everything in between. The headline number doesn’t tell you enough, you need to look deeper.

How ROE Is Calculated

ROE is a ratio that is expressed as a percentage of the net income divided by equity.

ROE = Net Income / Stockholder’s Equity

Net Income = Net income is calculated by starting with a company’s total revenue. From this, the cost of sales, along with any other expenses that the company incurred (including taxes) are subtracted.

Stockholder’s Equity = The amount of the funds contributed by the owners (the stockholders) plus the retained earnings (or losses). Stockholder’s Equity contains the following components which you will find on a complete company balance sheet:

Common Stock – Common stock at issue price.
Preferred Stock – Debt shrouded as equity at issue price.
Retained Earnings – Excess earnings kept on balance sheet.
Treasury Stock – Stock buybacks, total.
Capital Surplus – Equity value that exceeded issue price.

 

There are variations in accounting that change how these figures are reported – generally, the Common Stock + Capital Surplus will equal total equity invested in the company. ROE is stated as a static value at any given moment, typically for an entire year. If the company earned a profit but does not spend all the revenue, it will retain earnings that will carry over the next year. This adds to equity which will make future income returns comparisons more difficult since equity increases. Here are a few examples of different equity situations.

 

A Standard Example – Google (GOOG)

 

Google is a standard example of a pure play growth stock. The standard ROE calculation works well to tell you how the company is performing because the equity situation is uncomplicated. There are two main activities going on with Google: stock dilution and large amounts of retained earnings. Fortunately for shareholders, the increase in retained earnings exceeds the amount of stock dilution. The return on equity for Google this past year was 15% – a very healthy number. However, over the past 3 years the ROE has been trending down from an 18% figure in 2010.

 

The increase in common stock equity is caused by an increase issuance of shares over time (dilution).

 

Google Equity Summary
Net Income (2010): 8.5B
ROE (2010) : 18%
Net Income (2011): 9.7B
ROE (2010) : 17%
Net Income (2012): 10.8B
ROE (2012) : 15%
Stockholders’ Equity
2010 2011 2012
Misc Stocks Options Warrants
Redeemable Preferred Stock
Preferred Stock
Common Stock 22,835,000 20,264,000 18,235,000
Retained Earnings 48,342,000 37,605,000 27,868,000
Treasury Stock
Capital Surplus
Other Stockholder Equity 538,000 276,000 138,000
Total Stockholder Equity 71,715,000   58,145,000   46,241,000  

A Dividend Growth Example – Proctor And Gamble (PG)

 

Many investors don’t want dividends – they believe that a dividend is an admission by the company that their growth has slowed and the market opportunities have waned. Growth investing would end when a company can’t spend all its money – you would need to find these high growth companies early then sell them when they exit their initial growth spurt. A good example of a company that is spending every penny (and then some) to fund long term growth is Amazon (AMZN).

The other side to this is that good companies can be so profitable (high margins) that they can’t use all the cash available to fund their growth even if they wanted to. Amazon is funding future growth but its business is relatively low margin compared to PG. Being good stewards to the shareholder would necessitate that PG management return these excess funds through dividends or buybacks.

Proctor and Gamble (PG) has generated a ROE of 18% last year. Not bad for a company that has been around for decades.  Stock buybacks are indicated in the balance sheet as Treasury Stock and are a subtraction against Retained Earnings. The stock buybacks reduce equity, which means that the ROE for PG should represent what PG needed to grow its business.

Overall, PG has been a great manager for the investors. They can’t invest all the excess money, so by buying back stock they get a 18% ROE on that investment.

Proctor And Gamble Equity Summary
Net Income (2012): 10.8B

ROE (2012) : 18%

Stockholders’ Equity
2010 2011 2012
Misc Stocks Options Warrants
Redeemable Preferred Stock
Preferred Stock 1,195,000 1,234,000 1,277,000
Common Stock 4,008,000 4,008,000 4,008,000
Retained Earnings 75,349,000 70,682,000 64,614,000
Treasury Stock (69,604,000) (67,278,000) (61,309,000)
Capital Surplus 63,181,000 62,405,000 61,697,000
Other Stockholder Equity (10,690,000) (3,411,000) (9,172,000)
Total Stockholder Equity 63,439,000   67,640,000   61,439,00

Negative Equity – Lorillard (LO)

The equity section of the balance sheet contains entries related to equity only. Debt is found in the liability section of the balance sheet.  If a company not only uses retained earnings but also borrows money to reduce equity, you can get a situation that exists for Lorillard (LO) – negative equity. This also means that ROE is negative, which is outside the bounds of relevance.  ROE in this situation doesn’t tell what is really going on here.

 

If you have a screen that looks for some positive ROE value, you would miss LO. That’s unfortunate.

 

Lorillard can profitably do this for a couple of reasons. First, their industry is very mature and offers few opportunities to grow and invest (though LO has been increasing unit sales over the past years – against industry trends). LO earnings are so consistent and stable, they can comfortably borrow at today’s low interest rates to take out much higher cost equity. Over time, these borrowings pay for themselves when used to buyback shares.

 

In the past 5 years, earnings per share are up 64% – in large part due to these buybacks.

 

Net Income (2012): 1.1B
ROE (2012) : (Negative)

 

Stockholders’ Equity
2010 2011 2012
Misc Stocks Options Warrants
Redeemable Preferred Stock
Preferred Stock
Common Stock 5,000 5,000 2,000
Retained Earnings 2,351,000 2,059,000 1,666,000
Treasury Stock (4,190,000) (3,612,000) (2,026,000)
Capital Surplus 298,000 263,000 242,000
Other Stockholder Equity (241,000) (228,000) (109,000)
Total Stockholder Equity (1,777,000) (1,513,000) (225,000)

Conclusion

When evaluating a how well a company is performing, ROE is one criteria that can tell you quite a lot about how the company is using the money that was invested. Note that this measurement doesn’t tell you if a company is a good buy or much of anything about its valuation. Valuation is determined by stock price – which is the current cost of equity which is a different number than what the cost of equity used when money was first invested in a company.

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