Return on Equity (ROE) is one of Warren Buffett’s favorite multipliers and gives the investor the opportunity to evaluate the effectiveness of the company, clearly demonstrating the ratio of generated profit and equity capital. How do you find companies for a profitable investment using ROE?
What is ROE multiplier
The ROE (Return On Equity) ratio reflects the ratio of net income to equity capital of the company. In other words, it is a measure of how much profit the capital is generating.
For example, if the ROE is 20%, this means that every 1000 rubles of the company’s equity capital brings in a net profit of 200 rubles.
ROE can be used to assess the effectiveness and potential profitability of a company. For this, the multiplier is compared:
- with the same ratio of competing companies;
- with the company’s previous performance on the horizon for several years;
- with a return on low-risk assets.
How ROE is calculated
There is a formula to calculate the ROE multiplier:
ROE = net income / equity of the company (assets – debt) × 100%
All data for the calculation are published in the company’s financial statements and are publicly available.
For example, let’s calculate the ROE for Rosneft for 2019:
- net profit – 708 billion rubles;
- assets – 12,950 billion rubles;
- commitments – 5,043 billion rubles;
- equity – 7907 billion rubles.
ROE = 708/7907 × 100% = 8.95%
Accordingly, in 2019, every 100 rubles of Rosneft companies brought in a net profit of 8.95 rubles. It is rather difficult to draw a conclusion – whether this is a lot or a little, therefore ROE compared with multiples of other companies in the industry…
How to compare companies by ROE
It should be noted right away that the ROE multiplier is suitable for comparing companies belonging to the same sector. The reason for this is the different cyclicality, the peculiarities of taxation for each industry, which can lead to incorrect values when comparing.
Let’s compare the ROE of oil companies in 2019:
Comparing the ratios, it is already becoming clear that Rosneft has the lowest ROE, which means that its equity capital is performing worse than other companies.
How to Compare ROE Multiplier by Years
Return on equity indicator is not constant, its annual change can reach tens of percent. Therefore, the dynamics of the ROE ratio allows the investor to understand what is happening with the company’s return on equity – whether it is increasing or falling.
The steady increase in the ROE value over several years indicates that the company is growing and serves as a good signal for the long-term investor.
Let’s compare the ROE of oil companies over three years:
According to the ROE indicator, it can be seen that in the period from 2017 to 2019, Tatneft had the best indicator, but Lukoil has this coefficient more stable. Even as the margins of the rest of the companies fell in 2019, Lukoil’s ROE continued to grow.
Comparison with low-risk assets
The return on low-risk assets is the threshold below which the return on the company’s capital should not fall, otherwise it makes no sense for an investor to invest in the company’s shares, because investments in OFZs and bank deposits will bring about the same profit, but with much lower risks.
In October 2020, such threshold values are: the yield of standard bank deposits – up to 4.5% per annum, the yield of OFZs – 4.2–7% per annum.
High ROE is not always good
A high ROE does not always reflect a company’s high return on equity. The value of the return on equity multiplier can grow for two negative reasons:
- Loss streak… The company covers losses with its equity capital. If this trend continues for several years, then the volume of capital decreases markedly. If the company receives profit at the end of the year due to the previous decrease in capital, its ROE will increase sharply.
- Large debt obligations… A company’s equity is the difference between its assets and debt liabilities. The more debt, the less capital. Accordingly, the lower the equity capital, the higher the ROE ratio.