Do you want to learn what return on equity is?
Return on equity or ROE is a measure that is a determined by dividing net income with equity.
It gives you the ability to look at how efficiently a company is able to put their capital into work.
In this article, we will discuss what ROE is and what it means when you are buying stocks from the Philippine stocks exchange.
What is Return on Equity?
Return on Equity, more popularly known by its acronym ROE, is a financial ratio. Like all similar ratios, it is a measure of performance of a company. It comes in handy when analyzing how well a company is doing on a certain aspect.
“ROE is a performance measure used to assess the profitability of a company,” said Dan Dima-ala, former commercial financial analyst and entrepreneur who is behind the personal finance website Freedom Locker PH. “It’s the ratio of Net Income for every unit of Equity Invested in the business, or simply Net Income per Equity Invested.”
That is, the company’s annual return as measured by its net income is divided by book value, also known as shareholder’s equity. It is expressed in percent form. (As an aside, it can also be obtained by using dividend’s growth rate and earnings retention rate.)
For example, a company declares an annual return of 10 million pesos. Its book value is declared 100 million pesos. From the formula, the ROE is 10% (10M ÷ 100M = 0.1 x 100%).
Dima-ala added, “Because Shareholder’s Equity can change over the year, the average value of Equity is sometimes used in place of the ending value of Equity. Either way is fine as long as the analyst is consistent.”
What does ROE mean?
One rather interesting thing about the formula for ROE is that it joins up two financial documents of any company, its income statement and balance sheet.
The annual return is declared on the income statement, while on the other hand equity is shown on the balance sheet. By comparing these two values, it becomes an indicator of the firm’s ability to turn equity capital to profit and how they can achieve so efficiently.
“It measures profitability and is ultimately a measure of efficiency. It’s clearly a measure of profitability because it’s based on Net Income,” Dima-ala said. “But by efficiency, ROE also intends to examine how skillfully management has utilized the Shareholder’s Equity. Have they made the most out of what’s been invested? That is a question that ROE also tries to address.”
Dima-ala also remarked, “The goal of a firm is to maximize its Shareholder Value. A company does this when it earns a return that’s more than its costs from debt and equity. ROE tests this moderately well by evaluating the equity part. It highlights the earnings investors might get for investing in the company.”
Using the example above, the company has the ability to transform 10% equity capital to profit. Stated differently, the company can produce 10% profit for every peso of shareholder’s equity.
How is ROE interpreted?
It is obvious that stockholders would look for companies with good ROE.
“A higher ROE says, for the same amount of money invested, the company generates more in net income. This is favorable for investors who effectively earn more for every peso invested,” Dima-ala said. “A lower ROE tells the opposite.”
And just as with the other financial ratios, it is best not to take it as though it exists in a vacuum. In order to attain more meaning as an indicator on company’s financial performance, it is better used in comparisons.
“But it’s important to distinguish between high/low ROE vs. higher/lower ROE. ROE is a relative measure and should be measured either across time or against comparable companies,” Dima-ala said. “What’s high or low today will depend on what it’s been in the past, and/or what comparable companies are yielding.”
Limits of ROE
ROE has its own limitations.
Primarily, much of its value is derived from the numbers declared by the company which can be subject to errors that are inadvertent or deliberate.
“Because it’s based on net income, and net income is at the bottom of the financial statement (hence called the ‘bottom line’), it’s susceptible to manipulations from all line items in a company’s financial statements, with all sorts of white, grey, and black hat techniques,” Dima-ala said.
“These include sales recognition practices, changes in the life of an asset, and so on. Not to mention manipulations to Shareholder’s Equity such as artificially increasing dividends.”
Dima-ala however noted, “To be fair, developments in accounting standards have made malicious manipulations harder.”
One other consideration is the factor that ROE is measured against. For instance in interpreting the value of ROE, one must observe to compare apples with apples.
“It is for a given point in time. What’s fair for starting companies with high growth isn’t necessarily fair for mature companies,” Dima-ala remarked. “ROE is also based on past data and doesn’t take into account the impact of capital expenditures on future cash flow.”
ROE is one of the factors that stockholders can use to determine the fundamental value of companies. It is not only enough to understand what it measures and what its value means.
Dima-ala reminded, “ROE is also a combination of overall profitability (NI/Sales), asset turnover (Sales/Asset), and leverage (Asset/Equity). It’s worth noting that a company with respectable ROE might have achieved this through one of those 3 ways. And these 3 are markedly different reasons.”
“Say two companies have equal ROEs. One’s primary generator was profitability while the other’s was leverage. It’s best for investors to dig a little deeper.”
Thus, the best practice is to not take ROE in isolation. Rather, it is to be used in tandem with other strategies in value investing.
“ROEs, like all ratios and relative measures, must be taken as signals that guide further research. The typical investor probably doesn’t have unique information on ROE, so I’d advise against using them as your sole determinant for buy and sell decisions.”
“It’s best to use ROE in conjunction with other metrics. That said, it can be a useful tool when creating your shortlist,” Dima-ala said.
Where to look for data to compute ROE
So what resources are available to ordinary Pinoy investors?
There are almost 300 publicly listed stocks in the Philippines. Each one of them is required to file and submit quarterly reports, annual reports, and other material disclosures by regulatory bodies like the Securities and Exchange Commission and the Philippine Stocks Exchange.
Thus, you can start your research from the financial documents available on their websites.
You may also go ahead and click on the Financial Reports from the PSE Edge. These are arranged chronologically, with the most recent disclosures and files at the top of the page.
Lastly, you can also view Company List from PSE Edge arranged alphabetically. Simply click on the stock you’d like to research on, and it is going to lead you to such pertinent information such as stock data, company information, corporate leadership, financial reports, company disclosures and dividends and rights.Tags