Return on Equity

To calculate ROE in my spreadsheets, I use Net Income divided by Book Value. The ROE can generally say how efficient a company is.

An ROE from 10% to 15% is considered good. A sustained percentage above 20% is considered above average. Warrant Buffet prefers companies that have a 5 year average ROE of 15% and with no year below 10%.

What Warrant Buffet wants is above average ROE. The average ROE for companies has been an average of 10 to 12%. A good ROE is one that averages between 12% and 15%.

If the ROE is high you want to ensure that the company is not highly leveraged. Take a look at the Leverage Ratios, which is Assets over Book Value. A highly leveraged company can be vulnerable in recessionary times.

The reason I also check the ROE based on the comprehensive income because if these ratios are far apart, it could mean that the net income is not of good quality. If the ROE on Net Income and Comprehensive Income is far apart, it is warning sign.

There is a very interesting article in Forbes about how ROE can be artificially raised or lowered.

According to this Forbes article, reducing share equity by buying back shares can artificially increase ROE. Increasing debt, too, can artificially raise ROE. Liabilities are subtracted from assets to get that shareholder equity, so issuing bonds or preferred stock or taking out loans reduces the total.

Companies that issue shares may have their ROE artificially reduced. Also, paying off debts makes the ROE look worse. So when solid companies did the responsible thing and paid down debt during the financial meltdown, their ROEs suffered for it.

There are other factors, asset write-downs for example, which game ROE numbers, intentionally or not. According to this Forbes article, investors can take a good ROE seriously at companies that are not in the business of buying back shares or raising cash.

In other words, look carefully at factors than can affect either side of this equation, the book value or the net income. This is just one of many ratios that can be used to value a stock. Do not reply on any single ratio to determine your valuation of a company.

For a definition of ROE see Investopedia or see Wikipedia or see about.com.

This blog is meant for educational purposes only, and is not to provide investment advice. Before making any investment decision, you should always do your own research or consult an investment professional. See my site for an index to these blog entries and for stocks followed. Follow me on Twitter.