FOOL SCHOOL
Valuation: Return On Equity

January 16, 2002

We've looked at some of the more basic valuation measures in the first four articles in this mini-series. This is where it starts to get a little more complicated! Return on equity (ROE) gives you an idea of how much profit is being generated for every pound that shareholders have invested in the business. Since it is the shareholders who actually own the company, not the directors, their equity represents the owners' claims against a company's assets.

ROE is an important tool in an investor's box of tricks. It allows you to quickly gauge whether a company is a value creator or a cash consumer. By relating the earnings generated to the shareholders' equity, an investor can see how much cash is created from the existing assets. If the return on equity is 20%, then 20 pence of assets are created for each pound that was originally invested in the business. Clearly, the higher a company's ROE, the better the company, all else being equal. Which company would you prefer to invest your hard earned money into -- one that makes £5 profits from assets of £100, or one that makes that same £5 from assets of only £20?

We always encourage Fools to think of themselves as part owners of a business when they purchase shares in a big company. You are buying more than a share certificate, and more than a quoted price on the stock exchange. Money that is spent by your company is partly your money. When you see directors awarding themselves large bonus payments that are hardly deserved, that's partly your money they are pocketing. A lavish head office -- yep, that's your money again.

Because big businesses often produce detailed and complicated accounts, and each individual shareholder owns but a tiny tiny portion of that company, it is easy to lose sight of the big picture. The following example may help your understanding of the concept of shareholders' equity and ROE.

Ally's Abode

You inherit £150,000 and decide to buy an investment house for cash. An independent valuation of the house confirms its value at exactly £150,000. Straight after the purchase of that house, your balance sheet looks like this:

Assets 
One House          150,000 

Shareholders' Equity
Share Capital      150,000

Like all balance sheets, assets = liabilities + shareholders' equity. In this case, the liabilities are nil. Your £150,000 spent on the house is effectively the amount of share capital you've put into your little business. As this is an investment house, you expect to make a return on your equity investment. You hope to rent the house out to a load of students and receive £12,000 per annum, or 8% on your initial investment, after taxes.

In this case, it is clear that your return on equity is 8% (12,000/150,000). We are assuming your students are model tenants, pay all their bills on time and don't leave you with expensive repairs and maintenance bills. As we said this is only an example! Your profit and loss statement at the end of year one may look something like this:

Income              15,000
Less Tax @ 20%      (3,000)
                  --------
Net Profit          12,000
Less Dividends           -
                  --------
Retained Profits    12,000

And your balance sheet at the end of year one would look like this:

Assets
One House          150,000
Cash At Bank        12,000
                   -------
                   162,000

Shareholders' Equity
Share Capital      150,000
Retained Earnings   12,000
                   -------
                   162,000

ROE is calculated as:

      Net Profit
----------------------
 Shareholders' Equity


   12,000 
----------- = 0.08 or 8%
  150,000

The denominator (the bottom figure) of the ROE equation can be calculated in a few different ways. In this simple example, we've used the starting shareholders' equity of £150,000 as the basis to work out the annual return the little company has made. Some people would use the end of year (or closing) shareholders' equity amount of £162,000, for a ROE of 7.4%. Others would take an average of the opening and closing shareholders' equity being £156,000, for ROE of 7.7%.

In reality, the accounts of most big companies are much more complicated than this example, and the most realistic number to use for the denominator is the average shareholders' equity. For such a seemingly simple example, you can see how analysts' differing interpretations can result in such wide ranging ROE numbers.

Year 2 begins and your starting shareholders' equity is £162,000. With inflation running at 5% per annum, if you leave the annual rent bill unchanged at £12,000, you will slowly start seeing the real value of your income eroded. Also, if you only managed to receive total income of £12,000 versus your starting shareholders' equity of £162,000, your ROE falls from 8.0% to 7.4%.

Of course, if you had paid the year 1 net profit of £12,000 out in dividends to shareholders (i.e. yourself), your starting equity would have been £150,000 and the year 2 return would have been based on that lower starting point. Virtually all companies retain at least some earnings to invest back in the business in the hope of growing the business. A good company will increase its ROE year on year. Any company can grow its earnings, but only the better ones can grow their ROE.

In the next article we will look at the effect that goodwill can have on return on equity.

Other valuation articles:
The PE ratio
The PEG ratio
Price to Sales
Dividend Yield
Return on Equity and Goodwill
Uses of Return on Equity
Balance Sheet Basics
Discounted Cash Flow