Hey, I wanted to share my thoughts on a financial metric: Return On Equity. Return on equity calculation is: Net income/Shareholders Equity. I believe Return on Equity is useful, however it can mislead investors if you do not understand its limits. Return On Invested Capital (ROIC) is better for assessing earning power.
For example, if company A generates $20,000 in income and has $100,000 in equity, then return on equity is 20%. If company B generates $20,000 in income and has $200,000 in equity, then return on equity is 10%. Based on the above example, Company A is more efficient and requires fewer capital to generate the same profit as Company B.
However…
COMPANY A BALANCE SHEET
| Assets | $1,000,000 |
|---|---|
| Liabilities | $900,000 |
For Company A, If we add assets and subtract it by liabilities: Equity is $100,000. However, liabilities represent 90% of total assets ($900,000/$1,000,000). Debt to Equity ratio would be: 9.
COMPANY B BALANCE SHEET
| Assets | $300,000 |
|---|---|
| Liabilities | $100,000 |
For company B, if we add assets and subtract it by liabilities: Equity is $200,000. However, liabilities only represent 33% of total assets ($100,000/$1,000,000). Debt to Equity ratio would be 0.5.
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This explains why companies like Caterpillar (42% ROE) appears more profitable than Alphabet (23%). Or Nordstrom (33% ROE) compared with META (18%). ROE is higher for the former two not because they have more earning power, but because they are far more leveraged (carry more debt).
Conclusion:
Make sure you are checking the health of a company's balance sheet before comparing ROE between two companies. This is why I think ROE is overrated and prefer to use ROIC instead.
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