When it comes to value investing, one of the most important metrics to consider is Return on Equity (ROE). ROE is a measure of a company’s profitability, and it is calculated by dividing the company’s net income by its equity. The resulting percentage can help investors assess the company’s efficiency at generating profits with the capital it has available.
A good return on equity (ROE) for value investing is the higher, the better. However, investors must compare similar companies to each other to gauge what is good; a 20% ROE in utilities may be considered excellent but poor in technology. Company ROEs must be viewed over many years to discover trends.
What is return on equity?
Return on equity (ROE) calculates the amount of profit a business generates in relation to its equity. Equity is total assets minus total liabilities (also known as shareholders equity). Put another way; ROE measures how many dollars of profit are generated per every dollar of shareholder’s equity. It is an overall measure of how efficiently a company can generate profit with its equity and how efficiently a company can reinvest profit to generate further profits. The higher the ROE, the more sustainable the business. ROE is a helpful tool to give you a quick snapshot of the value of a company but does not provide an in-depth analysis.
What is a good return on equity?
A good return on equity is mainly dependent on the industry. For example, in a Capex heavy industry like utilities, an ROE of 10% may be considered very reasonable, whereas an asset-light industry like technology may expect to have an ROE of over 25%. Each company and each sector must be regarded as independent of each other. Comparing companies that are very similar to each other is a great way to gauge if a company’s ROE is above average or not.
The shareholder’s equity and earnings per share significantly affect a company’s value. For example, if a company had a shareholder’s equity of $20 a share and had $10 earnings per share (EPS) for the year, its shareholder’s equity would grow 50% to $30 per share as long as they retained all the earnings and paid no dividend. Share prices generally follow earnings, so in this case, it is likely that the company’s share price would increase substantially. Shareholders’ equity is roughly equal to a company’s intrinsic value. On the other hand, if a company had a shareholder’s equity of $200 per share and had $10 earnings per share for the year (the same EPS as the company in the example above), its shareholder’s equity would only grow 5% to $210 per share as long as they retained all the earnings and paid no dividend. In both cases, the EPS was the same, but their changes in growth were drastically different.
A steady increase in ROE usually indicates that management knows what to do with excess cash and is efficiently deploying capital. However, a declining ROE can indicate that management doesn’t know where to deploy capital efficiently; this could be due to poor management or saturation of the market they operate in.
So, what is a good ROE for value investing?
There is no one-size-fits-all answer to this question, as the ideal ROE can vary depending on the industry, the company’s stage of growth, and other factors. However, there are some general guidelines that value investors can use to evaluate a company’s ROE.
First and foremost, value investors are typically looking for companies with above-average ROE compared to their industry peers. A company with an ROE higher than the average for its industry could be an indicator of a company that is utilizing its assets efficiently and generating above-average profits.
A good benchmark for value investors to use is to look for companies with an ROE of at least 15%. While this is not a hard-and-fast rule, it is a reasonable benchmark to use when evaluating a company’s ROE.
It is important to keep in mind that ROE is not the only factor that should be considered when evaluating a company. A high ROE does not necessarily mean that a company is a good investment, and there may be other factors that could impact a company’s performance. Therefore, it is important to consider other metrics and factors when evaluating a company’s potential as a value investment.
In addition to the above guidelines, value investors may also want to consider a company’s historical ROE trends. If a company’s ROE has been consistently high over a number of years, it could be an indicator of a strong and stable business. Conversely, a company with a declining ROE trend could be a sign of trouble, and could be an indicator that the company is struggling to generate profits.
It is also important to consider a company’s capital structure when evaluating its ROE. A company with a high level of debt may have a higher ROE than a company with a lower level of debt, as the company is able to generate a higher return on its equity due to the use of leverage. However, a highly leveraged company can also be more vulnerable to economic downturns or other challenges, which could impact its ability to generate profits and repay its debts.
Limitations of return on equity
A company’s return on equity must be viewed over many years to understand how consistent the increase or decline in ROEs is. For example, if a company’s ROE has averaged 15% over the past ten years but in the most recent year spiked to 30%, it must be understood why that is. Is this growth sustainable? Or is it just a one-off event? Furthermore, a negative ROE, either from a net loss or negative shareholder’s equity, cannot be used to calculate the ROE or be used to compare to other companies. Another limitation is measuring the growth potential of young companies. New companies require much capital to start, resulting in a low ROE, but the low ROE may not indicate their future earnings potential.
Conclusion
In summary, a good return on equity for value investing can vary depending on the industry, the company’s stage of growth, and other factors. However, value investors should generally look for companies with an ROE above the average for their industry, and an ROE of at least 15%. Additionally, it is important to consider a company’s historical ROE trends, capital structure, and other factors when evaluating its potential as a value investment.
