ROE is net income divided by shareholders’ equity (i.e., book value). A typical number is a percentage in the teens. A lot of companies can boast of numbers much higher. The clunkers are in single digits.
There was a time when a handsome return on equity was taken as a sign of management skill. Here are the executives feeding their balance sheets with an eyedropper and delivering big results, so went the thinking. Low-ROE companies would be condemned for squandering capital, pouring money into white elephants that do little good for shareholders.
In the most extreme version of ROE worship, it was argued that the price/earnings multiple of a company should rise in proportion to the ROE. A company with equity of $10 billion and net income of $2 billion would be worth not twice as much, but four times as much, as a company with equity of $10 billion and a net of $1 billion.
There is a grain of logic to this line of valuation. If the company with a 20% ROE could plow back its earnings into expansions yielding the same rate of return, its earnings would compound at a magnificent 20% rate. It would indeed be deserving of a high P/E.
The fallacy lies in the assumption that newly deployed equity capital will enjoy the same return as existing equity. Consider Apple, among the leaders on our ROE list. If it could reinvest profits to get a 151% return it would do that. Instead, it is dispersing its profit to the shareholders via dividends and share buybacks. Profit at this asset-light company is a function of how many people want to buy phones at what price. It does not depend on Apple’s net worth.
A further complication in the ROE story is that the ratio cannot be calculated for companies with tiny or negative book values. Our table does not even show the highest ROEs in the YCharts database, which include 1,319% for Masco (which makes faucets) and 1,241% for Home Depot. These are meaningless numbers.
The drift of ROE toward irrelevance parallels the growing obsolescence of book value as a gauge of corporate worth. There’s more on that topic in our discussion of the price to book ratio.
Book value does, however, retain some validity for financial companies that need to display a classically strong balance sheet in order to be entrusted with customers’ assets. The disappointing ROE at Citigroup (3.8%) helps explain the below-market P/E multiple (11) that investors accord it.
Our advice on ROE: Keep an eye on it, use it to compare a company to its peers, but be aware of the metric’s limitations.
