If you’re searching for what is ROE, i’m assuming you are either new at the financial side of your business, going public or looking to invest in a company.
ROE stands for Return on Equity, equity referring to the capital that a company has raised. This includes assets and everything else that the company owns.
In a public limited company, equity specifically refers to the ownership of shares.
You may have heard investors trying to maximise a company’s Return on Equity. So what makes it so significant for making decisions?
The importance of Return on Equity when investing
If you’re looking to invest, the ROE of a firm will help you to determine 3 things:
- Efficiency (Is the management of the company effectively utilising resources and money invested?)
- Profitability (If high-level employees are efficiently running the business, it will automatically result in higher profits)
- Industry position (When comparing the ROE for businesses within an industry that sell similar products, it becomes easier for investors to compare and see which choice is best for investment)
Generally, the higher the ROE of a company, the better it is in all aspects.
If you’re looking for a specific percentage of ROE that can be deemed satisfactory or good, you should know that this percentage differs from industry to industry.
The ROE of all firms is taken into account and an industry average is set accordingly:
This graph will help you understand that if a firm has an ROE of 25% in healthcare, it is above industry average which makes it great for investing.
However, the same ROE for a firm in the cigarette industry is well below average so you’ll have to consider other factors as well if you strongly consider investing.
To know more about industry ROEs, check out NYU Stern’s calculations for Return on Equity by sector in the US for 2020.
Calculating Return on Equity
The formula for ROE is actually quite simple. All you need to do is divide these values and multiply by 100 to get a percentage.
If you’re considering multiple options for investing i.e. choosing between 2 or more companies, simply Google their financial statements for the current fiscal year.
For example, I just searched for Coca Cola’s financial statements on Google which directed me to the company’s official website, on the web page with the relevant details:
If I click on Earnings Release, I’ll find the company’s consolidated financial statements (i.e. its performance in different continents combined).
By noting down the Net Income and Shareholders Equity values from the Income statement and balance sheet, I can easily calculate the company’s ROE.
Similarly, I could calculate Pepsi’s ROE and then compare the two to see which is a better option for investing.
The beverage industry’s current average ROE is 12.09% which you can also use to set as a benchmark when choosing the right company for investing.
How to increase Return on Equity
This section is specifically for the management of a company that may be struggling to increase its ROE.
This often occurs when a company is expanding and needs to take charge of changes in business operations to improve the overall efficiency of the firm.
Here are some of the most effective ways that businesses normally opt for:
1. Going Public
This is one of the most common methods of increasing ROE.
You’re getting a huge influx of orders that exceeds your capacity but you want to cater to them and expand your business and boost sales.
However, an expansion means investment in capital, potentially labour and other aspects.
Unfortunately, in most cases, the liquidity position of a business does not support investment on such a large scale.
If you’re facing the same issue, going public is a good option to consider.
It will help you generate the equity you need to invest in capital and, if utilised properly, it will generate higher income.
The one risk associated with this option is losing ownership of your firm.
If any shareholder buys at least 50% of your outstanding shares, they will gain control of your firm.
To ensure you avoid this from happening, make sure you have enough cash to buy majority shares to retain ownership at all times.
2. Improved cash management
To improve their liquidity position, company management often keeps high cash reserves.
The purpose of this is to have cash on hand readily available incase of unprecedented situations e.g. if inventory gets damaged, a machine needs to be replaced, short-term debts need to be paid off, loans are given out etc.
Any issue related to the day-to-day operations of a business that could possibly require cash on hand is the reason why cash reserves exist.
However, this is not always optimal.
If the price of your stock is going down or as a private company your shareholders are not happy with the ROE being generated, you can use these cash reserves to either invest in capital to increase business capacity, hire skilled employees to improve efficiency or inject this cash directly into shareholder equity rather than retain profits as cash.
By investing your retained earnings back in the business, you can expand your business to cater to larger demand.
Hiring skilled employees does not alter business capacity but it can be used to alter the management strategies that oversee business operations, leading to more efficient business processes.
Lastly, dividing this cash between shareholders is the fastest way to make your shareholders happy as well as give the impression that your business is highly profitable.
This will attract more investors towards your business as they will see higher returns on their investment; thus, generating more equity for you.
However, it is important to remember that each situation is distinct and the right decision depends upon your company’s current standing.
Reinvesting into the business can prove to be more beneficial in the long run as compared to short term earnings.
3. Moving operations elsewhere
By elsewhere, I mean moving your operations to another country.
It sounds a bit of a stretch, but it can prove to be very effective in some cases.
In my experience, this works only if you have contacts or knowledge of the country you plan to shift your operations to.
However, you may be wondering why you’d do that at all.
Most companies do it to enjoy better tax rates, lower labor and raw material costs, cheaper overheads etc. – which is usually the case in developing countries.
Apple, a trillion dollar tech giant, has manufacturing plants in China and India only because it enjoys lower costs.
Similarly, retail brands like Zara and H&M also produce their clothing lines in developing countries like Bangladesh.
This brings me to why it is only effective in some cases.
You need to know the laws and regulations of every country.
All the brands that I have mentioned above have been accused of either poor working conditions, use of child labor and other such issues in their operations in developing countries.
Thus, this is an option that businesses opt for in very few cases.
If you plan to do it to enjoy lower tax rates or less government restrictions, you need to ensure that you hire management that is properly equipped to oversee operations.
4. Better utilising assets
This sounds pretty simple, but you’ll find it very common for companies to under utilise or over utilise their assets.
An example of overutilization could be a pharmaceutical store that is seeing a huge influx of orders due to COVID-19.
It loads a 20 tonne truck with 30 tonnes of medicines and products. That’s 10 tonnes more than it can carry.
In the short run, this saves the pharmacy the cost of buying another truck.
However, in the long run, it not only wears the truck out faster (depreciating its value as an asset) but it also runs the risk of damaging inventory because the truck may break down at some point due to heavy load.
However, that’s not as common as under-utilisation of assets.
This would occur if the same pharmacy owned 10 trucks but used only 5.
By not utilising these assets, it is wasting valuable resources that can be used to transport more medicines to make more sales.
If you’re in a similar situation, you can either sell your unused capital or use it as an opportunity to increase your supply.
Another great solution which is perfect for companies that do not have a consistent flow of orders, or those who practice Just In Time (JIT) production, is to rent out your capital when you don’t need it.
Trucks can be rented out on a day-to-day basis so that any day orders are high, the company can use the trucks for themselves.
However, if you’re in a tight liquidity position, you could also sell the extra capital equipment that you own and rent it out only when you need it.
This will save you maintenance, storage and other miscellaneous costs that come with ownership of equipment.
5. Increase your prices
Again, your decisions will only be effective if they are required.
If you increase prices in a competitive market where customers can buy similar offerings at a lower price from other brands, they will go for it.
However, it can also work IF you have extremely strong customer loyalty or you give customers a good reason to stay.
Take Apple for example. There are so many companies offering the same features, quality screens, cameras and so much more in their phones.
However, Apple phones still make the highest sales despite premium pricing due to the exceptional user interface and app optimisation that it offers, something that other brands have yet to offer.
As for Apple Earpods, the company was the first to come out with wireless headphones – giving it the first-mover advantage.
Thus, no matter which industry you may be in, you need to ensure that if you’re increasing prices, you give customers a good reason to buy your product.
This could be the quality, excellent customer service, amenities or any other feature that puts your product or offering ahead of competitors.
Conclusion
So that covers everything that you need to know about ROE, whether you’re looking to invest in a business or manage your own.
The important thing to remember is that along with ROE, other profitability ratios need to be calculated as well in order to assess the performance of a business.
Thus, for those of you who are looking to invest, I’ve taught you how to find the information you need to calculate these ratios.
Do your research and put in the effort of calculating these instead of opting for ‘herd behaviour’.
This is a term financial analysts use to describe the behaviour of investors and individuals who buy stock just because a lot of other people are.
For example, the price of gold went up as many people began to pull out of risky company stocks that were losing sales and investing the same money into safe commodities like gold.
Due to this sudden increase in demand, the price of gold went up.
However, the commodity’s price is still fluctuating and only time will tell whether the price will go back down or not once businesses start getting on their feet again.
As for investing in public companies, when you have the complete information available, it’s best to do the grunt work yourself rather than follow others.
Many people were investing in Apple uptil now, but due to COVID-19, the tech giant’s sales declined sharply as production plants remained closed for months.
That is why you need to think smartly about the long term benefits of your investments.
Safer investments will yield less, but investments with high returns are also very risky – meaning that there is a good chance you could lose your money.
As a financial analyst, I can tell you that neither option is better than the other.
It always depends on a case-to-case basis and luck plays a big role in investments, so do your research and then hope for the best!