Return on Equity Ratio

By Colin Nicholson

One of the more important measures of the rate of return being achieved by a company is called the return on equity ratio.

In very simple terms, this ratio is the profit made by the company as a percentage of the shareholders funds. So, if the company's profit for the last year was $100 million and the shareholders' funds invested in the business were $1,000 million, the return on equity is 100 1,000 100 = 10%

Clearly, the higher this percentage is the better. More importantly, we will want to see the return increasing over time.

However, in the industry, analysts tend to make various adjustments to the profit figure and the shareholders' funds figures shown in the accounts of a company. It is important to understand what these adjustments mean, even if the actual calculation is more difficult than most private investors wish to become involved with. The key point here is to understand what the analyst will have done.

The denominator is NPAT, or Net Profit After Tax. This sounds simple, but it isn't. The published net profit after tax will have been adjusted to remove the effects of non-recurring items in the profit calculation. In simple terms, this means getting back to the normal ongoing profit from carrying on business. However, there is more. Any outside equity interest and preference share dividends will have been removed from the calculated profit. This strips it back to the normal operating profit that is attributable to ordinary shareholders.

The numerator is Shareholders' Funds, which is also commonly called equity. Again, some adjustments are needed. Any outside equity interest in shareholders' funds and preference capital is removed from the total. This strips it back to the equity that is attributable to ordinary shareholders.

Ignoring the adjustments, the ratio is as follows:

Return on Equity (ROE) = NPAT Shareholders Funds (SHF) 100

This discussion again highlights the importance of understanding the definition of the ratio being used in any discussion.

Note: Outside Equity Interests occur where a company has a subsidiary that is only partly owned. The other shareholders in such a subsidiary are not those of the parent company, hence "outside" interests.

Colin Nicholson's books: Building Wealth in the Stock Market and The Psychology of Investing may be purchased from Colin's website www.bwts.com.au and good bookstores). Contact Colin at colin@bwts.com.au or through his web site where you may join the list to receive his free email newsletter.