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A useful tool for finding high-quality businesses

William Ryder explains how investors can use return on equity to assess the quality of a company.

Important notes

This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.

This article is more than 6 months old

It was correct at the time of publishing. Our views and any references to tax, investment and pension rules may have changed since then.

Most investors keep track of the returns they make on their own investments. But businesses also make investments to maintain and grow their profits, and shareholders ought to be keeping track of these too.

Companies essentially take money from shareholders to invest it in the real economy. They invest in things like new factories, IT systems and offices. A company that earns high returns on its investments will be able to grow its profits faster or return more money to shareholders through dividends than a business achieving more meagre results. Eventually strong business fundamentals should show up in the share price.

One way to assess the profitability of a company’s investments is through a metric called “return on equity”.

This article should not be viewed as personal advice, if you are unsure if a course of action is suitable please seek advice.

How to calculate return on equity

Return on equity is profit divided by shareholder equity, and it’s expressed as a percentage.

Shareholder equity is the portion of a company’s assets owned by shareholders. It’s calculated by subtracting a company’s liabilities (money owed to other people) from its assets. You can find it in the balance sheet, which is conveniently split into assets, liabilities and shareholder equity.

Profit is simple enough, but in some industries profit can often be bumpy from year to year. That means simply using last year’s profit might give a misleading picture. Often it’s worth taking an average of the last few years’ earnings to get a better picture of a company’s true earning potential.

How coronavirus has changed the way we look at shares

Let’s say a business has £100m in shareholder equity and makes £10m in profit. That would mean the business earns a 10% return on equity. If the business can keep reinvesting at that rate of return it will be able to grow its earnings, or pay attractive dividends to shareholders if future investment opportunities are thin on the ground.

What about debt

Companies can also get money to invest by borrowing it, which can flatter their return on equity. Look at the following example for a company which has £150m in assets. In 2019 it had £50m in liabilities, so we can subtract from assets to get £100m in shareholder equity. As above, £10m in profit would mean a 10% return on equity.

However, say the company borrows an extra £50m in 2020 and pays that to shareholders through a special dividend. In this case the liabilities would rise to £100m. Consequently shareholder equity would fall to just £50m. Now the same £10m of profit gives a 20% return on equity!

Balance Sheet 2019 2020
Assets £150m £150m
Liabilities £50m £100m
Shareholder Equity £100m £50m

This shows how debt can boost returns within a business. This isn’t necessarily a bad thing as it can increase shareholder returns during the good times, but high levels of debt can be a danger when conditions become more difficult.

How to use return on equity

In general a business that can invest shareholder capital at high rates of return can be considered high quality. Therefore, return on equity is a useful way of assessing the quality of a business, although no one number can ever perfectly encapsulate this. We think return on equity is best used alongside other metrics like profit margins and debt ratios to identify high quality businesses.

It’s also worth looking at the trend. If return on equity is rising it could be a sign that a business is making more profitable investments. However, it could also be for some other reason, perhaps because the business is taking on more debt which might not be such a good thing. In each case investors will need to look further in order to reach a conclusion.

Remember all investments and their income can fall as well as rise in value so you could get back less than you invest.

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    Important notes

    This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.

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