Return On Equity (ROE)
Return On Equity (ROE) is a profitability/efficiency metric that indicates how well a company uses investment funds (shareholders' equity) to generate profits / net income.
Return On Equity (ROE)
Return On Equity (ROE) is a profitability/efficiency metric that indicates how well a company uses investment funds (shareholders' equity) to generate profits / net income. ROE is also known as Return On Net Worth (RONW).
Return On Equity Formula
ROE is expressed as a percentage and calculated as:
Net income is the income available to common shareholders (before dividends paid to common stock holders but after dividends to preferred stock). Shareholder's equity does not include preferred shares. There are different figures quoted based on the time period required.
- ROE Annual : uses the net income from the latest company fiscal year divided by the average number of common shares over the same period
- ROE TTM: uses the net income for the Trailing Twelve Months (TTM), most recent 12 month period, divided by the average number of common shares over the same period
- ROE Quarterly: uses the net income for the most recent quarter divided by the average number of common shares over the same period
Return on Equity Interpretation
Return On Equity measures a corporation's profitability by revealing how much profit a company generates with the money shareholders have invested. But the ratio strongly depends on many factors such as:
- value of the shareholders' equity
- level of debt
- write-downs and share buybacks
Some industries tend to have higher returns on equity than others. As a result, comparisons of returns on equity are generally most meaningful among companies within the same industry, and the definition of a "high" or "low" ratio should be made within this context.
DuPont Analysis, introduced by the Dupont Corporation back in the 1920s, breaks down the Return On Equity into three distinct elements, allowing analysts to compare companies in similar industries. The three elements are:
- Operating Efficiency; and
- Financial leverage.
The DuPont Analysis is known by several other names including DuPont Equation and DuPont Formula.
Good quantitative factors exhibit relationships with stock returns that not only have a fundamental and/or theoretical basis for stock returns but are also stable and persistent over time. The Return On Equity is such a factor, having been correlated with past stock returns for years and also expected to be correlated with future returns.
The investment horizon is referred to as "rebalance period" in Qualitative Analysis, indicating the period of time a stock is held before refreshing the portfolio holdings. While some quantitative factors achieve good results with weekly, monthly or quarterly rebalance, the Return On Equity stock factor works best with a short rebalance period of 1 week to 3 months to exhibit "good" results.
The Quantitative Analyst assesses individual stock factors by:
- separating the stocks into quintiles (or deciles) based on the value of the factor
- calculating the performance of each quintile based on rebalance period and total back-test period
- analyzing the spread of performance between Quintile 1 to Quintile 5
Ideally the performance spread should be "monotonic", meaning that Quintile 1 outperforms Quintile 2, Quintile 2 outperforms Quintile 3, and so forth.
Using the process described above, the stocks from the Russell3000 Index were evaluated over the 10 year backtest period 2005-2014 with a weekly rebalance period, using the Quarterly Return On Equity.
In Quantitative Analysis, single factor back-tests are not executed to generate real-life performance figures or to outdo a benchmark. At this stage the Technical Analyst is simply trying to identify whether the stock factor contains useful predictive value. As can be seen from the above column chart, the quintiles exhibit monotonic behavior, meaning that the quarterly ROE provides useful predictive value. There are many other considerations involved in the construction of a portfolio that will change the performance numbers.