Return On Equity

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One of the more telling ratios than can be used in stock analysis is Return on Equity (ROE). This ratio can tell the investor how good the company is at improving and increasing shareholder equity. It is important to realise that this ratio is not useful over the short term. In-fact a high return on equity over the short term is completely useless, as it tells you nothing about the actual strength of the company.

An analysis of historic figures shows you how sustainable the current return on equity actually is. A company that can produce a sustainable, positive, non-volatile return on equity can be a great long term investment!

What Is Shareholder Equity?

Shareholder equity is the company’s Total Assets – Total Liabilities; or this can be stated as:

Share Capital + Retained Earnings – Treasury Shares

In simple terms this is the initial capital that was invested within the company, along with any investments made after, such as retained earnings from operations or further stock issuances.

How Does Return On Equity Work?

 ROE = Net Income/Shareholder's Equity

 Return on equity is basically how much income the company is generating with the capital it has available to it.

 

How Can ROE Be An Indicator Of Future Returns?

Take for example Coca Cola (NYSE: KO) – currently, as of September 2012 the company produced a 27% return on shareholder equity. Ten years ago, the company was producing a 27% return on shareholder equity.  The ratio has varied in-between but never dropping lower than 25% ROE and moving as high a 43.5%.

On the other hand, Bank of American and Alcoa provide a very good example of what not to look for in ROE ratios:

Bank of America (NYSE: BAC)

The stock had a return on shareholder equity of 20% ten years ago - 31st Dec 2002. Currently the Bank is producing a ROE of 1.9% for its shareholders. The ROE the company has produced over the past ten years has varied from 25% down to -2.2% and then up again to 4.7%.

Alcoa (NYSE: AA)

The aluminium producer has also seen similar variation in its ROE. Ten years ago the company had a ROE of 4%, this rose as high as 16% in 2008. Before crashing down to -14% in September 2009 rising slowly to 5.5% in mid-2011 and currently it stands at -1.4%.

The result of these highly erratic figures has been a roller coaster ride for shareholders.  Bank of America shareholders have seen a return- at the lowest point - of 92% on their shares over the last ten years. At the highest investors would have seen a return of only 21.5%. Alcoa shareholders on the other hand have seen smaller loses, down only 60% in at some points during the last 10 years.

Although these years have included a recessionary economic climate it does reveal a lot about the businesses. Even in the current climate and throughout 2008/2009, KO has not suffered a fall in its ROE and that is where the strength in the business lies. As opposed to the banks and commodity companies who have unpredictable shareholder returns and therefore an unpredictable share price.

 

This chart shows the variation in shareholder ROE between the three companies. The 2 period moving averages highlight the variations in ROE. The chart shows that both Alcoa and Bank of America have produced highly volatile ROE figures for the past 10 years, however, Coca Cola has produced relatively stable returns - apart from an erratic period in 2011.

This volatility in the ROE does not really mean much with looking at the share prices over the same period:

 

A quick glance over the share price for these firms reveals all. Both Alcoa and BAC have seen highly volatile share prices, almost incline with their erratic ROE figures. Coke shareholders on the other hand, have seen a steady appreciation in the value of their shares as the company maintains a steady return on its equity and steadily increases the value of its business.

 

Conclusion

Overall historic return on equity can be a good indicator of future shareholder returns however, it does have limitations and should be coupled with other fundamental analysis. Most importantly though it should be looked at over a long period of time and short term results should not be taken lightly.

Data Source: YCharts



RupertHargreav has no position in any stocks mentioned. The Motley Fool recommends The Coca-Cola Company. The Motley Fool owns shares of Bank of America. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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