Why Return-On-Equity Is So Important

Here’s a post for new investors or a helpful reminder for more experienced investors.

When you’re looking at a company, the single-most important number is return-on-equity. Forget head-and-shoulders, forget bear traps and double bottoms, forget volume, forget stochastics. Return-on-equity tells you more than anything else about how well a company is performing. It’s the best measure of efficiency, bar none. In short, ROE tells us how much we get for how much we got.

ROE can be deconstucted down into three parts (warning, math ahead). Profits margins, asset turnover and leverage. Think of it this way:

Profit margin is profits divided by sales.

Asset turnover is sales divided by assets.

Leverage is assets (stuff you have) divided by equity (stuff you own).

If we multiply them it will look like this:

(Profits) (Sales) (Assets)
——– X ——– X ——– = ROE
(Sales) (Assets) (Equity)

I pass the graphics savings on to you.

The mathematically inclined will see that the two “sales” and two “assets” cancel each other out. And we’re left with profits divided by equity, or return-on-equity.

(Profits) (Sales) (Assets)
——– X ——– X ——– = ROE
(Sales) (Assets) (Equity)

See, easy.

The beauty of ROE is that it works for every company. You can compare General Electric to a lemonade stand. A company like Wal-Mart may have a teeny profit margin (around 3.5% last year), but incredible asset turnover. Wal-Mart is really just one big inventory control machine. A financial company like JPMorgan has 12 times more assets than equity, but it generates less than a penny of revenue for each dollar of assets.

Everything here balances out. If you want to borrow more to increase your leverage, your interest costs will hurt your profit margin. Or, you can increase your asset turnover by lowering your margins. There’s no way to shortcut except by doing better business.

For ease of explanation, I’m simplifying this but there are two other ways to bump up your ROE. One is by lowering your taxes and the other is by lowering your borrowing costs. Typically, however, companies aren’t in control of these variables.

Posted by on September 5th, 2012 at 10:58 am

The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.