Calculation

Return on equity is calculated by dividing a company’s net income (income statement) minus preferred dividends (cash flow statement) by average common stockholders’ equity (balance sheet).

Interpretation

Return on equity (ROE) is a profitability ratio and one of Warren Buffett’s key criteria when looking for strong companies to invest in.

ROE shows how much money a company can generate with the money invested by its shareholders, i.e. shareholders’ equity.

Since shareholders’ equity consists in part of retained earnings, which is the amount of net income left after paying dividends to shareholders or buying back shares, consistently high ROEs demonstrate that a company is good at investing the retained earnings in a profitable way.

ROE vs. ROIC – What’s the Difference?

Whereas ROE compares the profit generated by a company only to the shareholders’ equity, return on invested capital (ROIC) compares the profits to both equity and any debt financing.

When looking at companies with little debt, ROE is often the quicker way to gauge profitability, and will produce similar numbers to ROIC. However, companies that took on more debt will show increasingly diverging numbers between ROE and ROIC.

Comparison #1: Comparison to historic ROEs

First, we want to see how the current ROE compares to historic values. According to Pat Dorsey, consistently high ROEs of above 15% over several years are often an indicator that a company benefits from a durable competitive advantage.

As an example, let’s look at Alphabet’s historic return on equity values. Over the past 10 years, Alphabet delivered a median ROE of 16%, ranging pretty consistently between 14 and 19%, with a dip to 9% in 2017.

As of today (January 15, 2022), its current ROE (TTM) of 31% is quite a bit higher than the median and previous years, and the source of this might need some further investigation.

Overall, a pretty good sign of a durable competitive advantage.

Comparison #2: Competitor comparison

Next, let’s look at some of Alphabet’s major competitors in the advertising field. Note that the data below shows the overall performance of each company, and not just profits from advertising. Therefore, a direct comparison is difficult, and this discrepancy needs to be considered when trying to draw any conclusions from such a comparison.

However, we can see that all the competitors achieved ROE values above 15% in the past several years, suggesting they are able to use their shareholders’ equity efficiently to generate a profit.

Another thing to point out is Apple’s (AAPL) increasing ROE from around 40% in 2017 to >70% in 2020. While these ROEs might look impressive, they also show one caveat of using ROE to assess profitability. The increase in ROEs in this case was skewed by massive share repurchases, and not increased net profits alone.

Comparison #3: Compare to cost of capital

According to Tim Koller and colleagues, a company creates value when it is able to achieve ROIC above its cost of capital. Similarly, for a company with modest debt, we can assume that ROEs are somewhere in the range of ROIC. Therefore, if a company is able to consistently deliver ROEs above the cost of capital, it’s a pretty good sign that the company is creating long-term shareholder value.

Cost of capital is generally determined by calculating a company’s weighted average cost of capital (WACC). The calculation is a bit complicated, and a more detailed article on the topic will follow.

For now, using an online calculator, we can see that Alphabet’s current WACC is in the 7-10% range. Therefore, ROE levels above 15% clearly indicate that profits exceed WACC, and shareholder value is created.

Advantages and limitations of ROE

Advantages

ROE is easier to calculate than ROIC, and can be easily found on most financial websites.

Limitations

First, comparison of ROE to competitors is often challenging due to varying capital structures. Even different divisions or product categories within a company can generate vastly different returns on equity.

Second, an increasing ROE doesn’t necessarily mean that a company is performing better. ROEs can be skewed, for example by share repurchases, or by taking on large amounts of debt, which can be leveraged to boost profits.

And third, some excellent companies might show low ROEs for long periods as they are building out moats and/or investing in growth initiatives, and our her metrics should be used to identify value creation.

Bottom Line

Look for companies that can consistently achieve ROEs above 15%.