Our valuation series continues with a popular profitability ratio, Return on Equity (ROE). Many of the biggest gainers in stock market history exhibited high and increasing return on equity. It is a metric all portfolio managers, analysts and traders keep a close eye on. The financial newspaper, Investor’s Business Daily, is a major proponent of the ratio, incorporating it into their investing methodology.1 And there have been numerous white papers written demonstrating the outperformance of companies with high ROEs.2

In its basic form, the calculation is pretty simple: Net Income/ Shareholders Equity

Net income is the bottom line profit that remains after all expenses have been paid, including taxes, depreciation and amortization. Shareholders equity is essentially the difference between the assets and liabilities on a balance sheet. ROE measures the amount of earnings generated by each dollar of shareholder equity.3 Companies with ROEs of at least 15-20% are considered doing very well for their shareholders.4

Problems with ROE

But you have to be careful when relying solely on return on equity, because it can be easily influenced by management. Net income, is the bottom line profit which is can be manipulated by management. The creative use of capital gains and losses, depreciation and amortization as well as ‘extraordinary items’ can make a company’s earnings reports biased.

Increasing debt in the capital structure can also improve ROE without any corresponding gains in company performance. Also, return on equity is a popular metric used when deciding on management compensation. So it may be in the management’s interests to maximize the ROE to boost the stock price, possibly at the expense of other stakeholders in the company, such as bondholders. Warren Buffett has said that companies that are only able to earn good returns on equity by employing significant debt should be viewed suspiciously.5

The Equity Multiplier

Return on equity can be broken down as the product of three smaller ratios- profit margin, asset turnover and the equity multiplier. Known as the DuPont method, it gives an investor a better sense of what the company’s ROE is revealing.6

Profit margin and asset turnover look at how well management is utilizing various resources. The equity multiplier is a leverage ratio that determines how a company is financing its assets and operations, which can be done in two ways, though the issuance of equity or by incurring debt. The equity multiplier can reveal if ROE is being increased through potentially risky increased debt levels.

The ratio is calculated by dividing Total Assets by Shareholder Equity. Assuming total assets of the company are 1000 and shareholder equity is 250, the equity multiplier is 4. This means that 25% of assets are being financed by equity (and the remaining 75% is funded by debt). The higher the equity multiplier, the more the company’s assets are being financed by debt. By looking at this ratio over time, an investor can get a good idea of what’s really driving ROE at a company.

To be fair, a high equity multiplier (and thus higher debt levels) isn’t necessarily a bad thing. Financing through debt is typically cheaper than through equity (typically via a secondary stock offering, where a significant cut of total proceeds will go to the underwriting investment banks). This is especially true with interest rates as low as they are currently. As long as debt levels don’t get too high this may be an effective strategy for management. But if debt levels rise too much it may negatively affect bondholders, especially if the company’s credit sustains a downgrade from a rating agency. And if the business cycle turns when a company is loaded up with debt, it may have a hard time meeting its obligations.

Return on Invested Capital

An alternative ratio that’s en vogue among the analyst community is Return on Invested Capital or ROIC. This metric was used by 672 companies in 2015 which is up 42% over five years, a testament to its increasing popularity.7 A cross between a profitability and an efficiency ratio that analyzes cash flow generation but also measures how well managers allocate capital.8 It reveals the amount of new cash created by all capital investments.

The ratio is: Adjusted Operating Income/ (Equity plus Debt) – Cash

The ‘return’ portion of the ratio is more focused on the operating performance of the company than net income. It is considered by some a better indicator of company performance than ROE, which uses net income as its ‘return’ which often doesn’t have much to do with the true profitability of the company as much as how the accounting was done.

Another reason for its popularity over ROE is that the denominator takes into account all sources of capital to the company, including debt. Because it also includes debt as a source of capital, it provides a picture of how management is running the entire company, not just for shareholders.

General Motors continuously analyzes ROIC for itself. GM’s CFO offered, “ROIC provides the clearest picture of how we are managing our capital and our business.”9 According to the Wall Street Journal, this ratio may have helped GM stave off activist investors.10