Return on Equity (ROE)
The return on equity ratio (ROE) is a quality metric. ROE measures how efficiently a company utilises funds to produce profit. A higher ROE is preferential but it is entirely industry specific.
The fundamental investor looks for an ROE that is stable and increasing over the last few years.
- We can compare a company’s ROE to its industry to gauge how efficient the company is relative to the industry for a fair comparison. Note: Important to compare ROE within industry because ROE varies dramatically between industries.
- We can compare a company’s ROE to its historical ROE to gauge if it is more efficient than its history.
These three quality metrics can confuse investors. They allow for a quick comparison between companies, but how can these metrics be differentiated?
ROE measures the efficiency of a company to produce profits relative to its shareholders equity. The shareholders equity is total assets minus total liabilities, which can be found on the firms balance sheet. It is the remaining funds if the company were to liquidate, and represents the proportion of the business which wasn’t financed with debt.
ROA measures the efficiency of a company to produce profits relative to its assets. A companies total assets is calculated by adding its shareholders equity to the total liabilities or debt. ROA provides a more accurate representation of the company’s performance than ROE, given the inclusion of debt in its calculation. A high ROE but low ROA suggests a highly indebted company.
ROIC measures the efficiency of a company to produce profits relative to its total capital. ROIC uses NOPAT rather than net income in the numerator of the equation. NOPAT is the operating income after taxes. It indicates what the core business earns after tax and doesn’t include debt, cash, interest expense or other non-operating expenses. Invested capital, the denominator of the equation, is the total sum of money raised through equity and debt. ROIC reflects the return on all the invested capital, and therefore is the most accurate reflection of the performance of the company’s operations.