“Focus on return on equity, not earnings per share.”

One of my favorite Buffett quotes of all time. Focusing on the returns on equity (ROE) and not earnings forces us to recognize the performance of the company in how they manage their capital, versus strictly the earnings and nothing else.

Buffett likes to compare stock returns to the returns you would get from a 10-year T-bill. He says that he would rather receive a 10% return for his investment in a company. Instead of the 5% return, you would receive from the bond.

In our continuing series on analyzing the profitability of a company, we will be doing a deep dive into the ratio, return on equity, or ROE.

Another great quote from Buffett in regards to return on equity:

“If you earn high enough returns on equity and you can keep employing more of that equity at the same rate — that’s also difficult to do — you know, the world compounds very fast.”

If a company can re-invest their capital at great rates, that makes it a truly wonderful company, of which those are difficult to find.

In today’s post, we are going to explore return on equity:

- What is Return on Equity
- How do we calculate Return on Equity
- Pros and Cons of Return on Equity
- Industry comparisons of Return on Equity

**What is Return on Equity** (ROE)?

According to Investopedia:

“*Return on
equity (ROE) is a measure of financial performance calculated by
dividing net income by shareholders’ equity. Because
shareholders’ equity is equal to a company’s assets minus its debt, ROE could
be thought of as the return on net assets*.”

Return on equity is considered one of the best ratios to measure how well management uses it’s company’s assets to create more profit.

We can only calculate return on equity on company’s that have positive numbers for both net income and shareholder equity. If a company is losing money from the bottom line, like Snapchat, for example, then they are not going to have a return on equity.

Return on equity is best when used to compare company’s in like industries; it is not a stand-alone metric that can tell you a company is good or bad, more on this in a little bit.

The key to finding great companies that are great investments for the long-term involves finding companies that earn great returns on equity over many years. Of course, the next trick is to find it at a good price.

**How to Calculate Return on Equity**?

We have spent some learning what the return on equity ratio is all about, let’s take a look at the formula and learn how to calculate a return on equity.

The formula for return on equity is short but sweet. It is simple and easy to use.

**Return on Equity =
Net Sales / Average Common Shareholder Equity for the Period**

Luckily, we have worked with these numbers before. They will be easier for us to find.

The net sales we will find on the income statement, and the average common shareholder equity we will find on the balance sheet.

Remember that shareholder equity is total assets minus total liabilities. Shareholder equity is a combination of retained earnings from the income statement and capital paid in by the owners, usually at the founding of the business.

Let’s take a look at several companies to get an idea of how this ratio works.

The first company I would like to analyze the financials for our return on equity formula is Disney (DIS).

First, I am going to look up their latest 10-k from Sept 28, 2019. As always, all numbers will be in millions unless otherwise stated.

As you can see from the highlighted section, Disney had a net income of $11,584.

Now, we will look at the balance sheet for Disney.

We can see from the above chart that Disney had Total Shareholder Equity of:

- 2018 – $48,773
- 2019 – $88,877

Ok, now let’s plug the numbers into our formula.

Return on Equity = $11,584 / ( ($48,773 + $88,877 ) / 2 )

Return on Equity = $11,584 / $68,825

Return on Equity = 16.83%

Pretty easy, huh? Your probably asking, is this a good ROE? We will get to that answer in good time. For now, realize that for every dollar that Disney earns, they are returning 16.83 cents to the shareholders.

A note about ROE, a ratio between 15% to 20% is right where you want to be; of course, higher is better.

The next company I would like to take a look at is Hormel (HRL). One of my favorite dividend aristocrats, and long on my wish list as a company that I would like to own, but alas, I wait for the price fall to my margin of safety.

We will look at the latest 10-k for Hormel, which is dated October 28, 2018.

First, we will pull up the income statement for Hormel.

We can see from the above income statement that the net income is $1,012. Also, notice that Hormel refers to net income as net earnings. You will notice as you work with more and more financials that many companies use similar terminology for the same term. In this case, net income equals net earnings.

Another note, Hormel, also lists the income statement as consolidated statements of operations and the balance sheet as consolidated statements of financial position. Please don’t let that throw you off; if you are unsure, pick the one that is most logical to you or click on the link and look at what each statement contains and you can find the one you are looking for that way.

Now, let’s look at the balance sheet for Hormel.

Ok, the shareholders’ equity for Hormel for:

- 2018 – $4,936
- 2019 – $5,601

Now that we have our numbers let’s plug them into our formula

Return on Equity = $1,012 / (( $4,936 + $5,601 ) / 2)

Return on Equity = $1,012 / $5,269

Return on Equity = 19.21%

Again, easy to calculate, and it tells us that Hormel was able to generate 19.21 cents per each dollar of shareholder equity.

We have looked at two established, more mature companies in retail and consumer goods. I want to take a look at a more conservative industry, like banking.

Let’s look at a relatively unknown bank that is extremely well run and has a fantastic reputation for customer service, on par with Disney.

First Republic (FRC) is a regional bank that operates out of the Pacific Northwest with a market cap of $17.66 B, peanuts compared to the big boys Wells Fargo and JP Morgan.

Ok, I will pull the numbers from the latest 10-k, December 31, 2018.

- Net sales – $796.1
- 2017 Total Shareholder Equity – $7,818.3
- 2018 Total Shareholder Equity – $8,677.7

Now that we have our numbers let’s calculate the return on equity for First Republic.

Return on Equity = $796.1 (( $7,818.3 + $8,677.7) / 2)

Return on Equity = $796.1 / $8,248

Return on Equity = 9.65%

So, First Republic had a return on equity of 9.65% for the year ending 2018, so they earned 9.65 cents per $1 per each dollar of shareholder equity.

Not as good as the other companies we already analyzed, but banks operate under different conditions and have to use their capital differently than other companies because of regulations.

The interesting thing about this formula is that it is an easy way to find a profitable company and a great way to screen for wonderful companies. If you run a quick search on some of the more popular companies:

- Tesla (TSLA) -14.94
- Netflix (NFLX) 29.12
- Facebook 19.66
- Uber (UBER) -69.37
- Amazon (AMZN) 21.95

Interesting little chart, isn’t it? In the case of both Tesla and Uber, they are carrying a negative return on equity because, currently, they both have negative net income. In the case of Uber, they are a new IPO and have struggled out of the gate, and Tesla is just a hot mess when you look at the financials.

One of the cool uses of this ratio is the ability to screen out companies that are not profitable quickly, or that are not generating returns for us, the shareholders.

**Pros and Cons of Return on Equity**

Now that we have discussed what return on equity is, let’s take a look at some of the advantages and disadvantages of the ratio.

First up, the advantages:

**Management**– return on equity allows investors to analyze management because the components that go into the ratio include asset management, leverage, and pricing. Great asset management causes ROE to improve using fewer assets, as well as a great profit margin, which we see in the earnings. Leverage, which is the ability to take on debt, also raises ROE when used judiciously, more on this in a moment.**Comparison**– ROE focuses on return money to shareholders and is best used to compare to other companies. Earnings and profits can vary across sectors, sometimes wildly and are sometimes difficult to compare. But, ROE takes those earnings and makes it easy to compare across sectors.

Now we will look at the cons of using a return on equity ratio:

**Leverage**– companies have two options when considering raising capital to improve their profits. It can take on debt, or it can take on new equity owners. Whichever route they choose, the company must choose wisely. Return on equity only focuses on the shareholders’ equity, not the debt. The extra debt means that the company could be highly levered with a ton of risky debt, which could juice the return on equity by providing more profits. A better option is to utilize other ratios, such as return on invested capital, along with ROE, to get a complete picture of the financials of the company.**Negative return on equity with startups**– Companies that are just starting are going to have a negative net income, in all likelihood. Negative ROE could lead to missing out on companies with huge shareholder investment. There is potential that we might miss a tremendous opportunity because the ROE is negative from the startup. Analysts must decipher the shareholders’ capital and determine how long it has been in place. Newer capital can take time to produce, which will increase the ROE.**Subjectivity**– return on equity is based on net income, rather than revenue. Net income is the revenue minus expenses, or costs of goods sold. Most investors understand revenues or the top line. Costs of goods sold are subject to many manipulations by the companies accounting policies, either intentional or unintentional. For example, a company with a large number of assets will have a large depreciation expense. The depreciation expense lowers the ROE compared to a company with fewer assets. Companies can also decide when or how they want to write down their assets, which will also impact the return on equity. The bottom line, there is the possibility of manipulation of costs of goods sold, which can make ROE unreliable.

Please remember that we never use one metric to analyze a company, all of the ratios and formulas that we use are tools to help us find a wonderful company. As you become more comfortable with these ratios and deciphering financial reports, you will find the ratios and formulas that work best for you.

**Sector Comparisons of Return on Equity**

When calculating return on equity for a company, one of the best ways to use the ratio is as a comparison to other companies, either in the same industry or across industries.

Professor Aswath Damodaran takes the time to calculate the return on equity across all industries; you can find the webpage here. I am going to create a chart of the more popular industries that you can use for reference when using the ROE for comparison purposes.

Across all sectors of the market, Professor Damodaran found that the average return on equity is 12.25%. The chart I am referencing is something that he updates every year. He is a go-to resource for me for any market data that I need; his website is a must if you are interested in finance at all.

As an aside, his class at NYE Stern on corporate finance and valuation are fantastic, and they are free! You can elect to watch his lectures via YouTube videos, and I have cut my teeth listening to his lectures many times. That’s old-timer for learned a lot from him, in case you were wondering.

The above chart will help you get a start on analyzing companies with an ROE because you can use the above numbers to get a feel for whether the company you are evaluating is effective at creating more profits with their equity.

Not only will comparing to others in their industry but also across industries will this chart help you. It is not enough to compare Apple to Microsoft, or Walmart to Amazon. We must also look at how it is doing in its industry.

**Final Thoughts**

Return on equity is a powerful ratio that can help us screen for shareholder friendly companies that are fantastic at creating value from their assets.

It is a simple, easy to use ratio and all the information to calculate the ratio is easy to find on the financials, coming from both the income statement and balance sheet.

There are some downfalls to the ratio that we discussed that you must be aware of, and as I have pointed out today, as well as, in the past, we must use all of our tools to find a great company.

It is not enough to find a company with a great ROE and buy it based on that; we must do a thorough analysis using all the tools to find the best investment for us. Whether you focus on financials like I enjoy doing, or if you are more comfortable with retail or technology.

Return on equity is a quick way to find a great company to start your research.

As always, thank you for taking the time to read this post, and I hope you find something of value that you can use on your investment journey.

If I can be of any further assistance or if you have any questions, please don’t hesitate to reach out, I am here to help if I can.

Take care,

Dave