Shareholders’ equity is your ownership in the business. That is why analyzing the return on shareholders’ equity is so important. This key measure of profitability is also useful for gaining insight into a company’s sustainable earnings growth and valuation.
The balance sheet shows a company’s resources at a point in time. A company uses its resources to generate revenues and earnings, as depicted by the income statement. Profitability measures how well management is utilizing these resources to produce value for shareholders. Return on equity (ROE) is the principle measure of a company’s ability to generate profit.
Return on equity bridges the income statement with the balance sheet by relating net income to shareholders’ equity. The more net income produced per dollar of equity, the more profitable the company:
Return on Equity = Net Income / Common Shareholders’ Equity
Net income is from continuing operations and before extraordinary items. Common shareholders’ equity excludes preferred stock, and is the average of the beginning and end of year, or period under review.
Get behind the number to find out where a company’s return on equity is coming from. Return on equity should be rising because of higher pretax margins (income before taxes / revenues) and asset utilization (how efficiently assets are being utilized to generate revenues, or revenues / total assets), as opposed to a lower tax rate and higher leverage or debt. I call this the quality of a company’s profitability.
Let’s look at Apple (AAPL) to illustrate. Return on equity soared to 27.6% in the latest 12-months from 5.7% in fiscal 2004. Supported primarily by the iPod, surging sales boosted pretax margins to 19.9% from 4.5% in the same time period. The sharp rise in profitability was from operations and not from a declining tax rate or other non-operating sources. Leverage did not enhance return on equity either as Apple has no long-term debt. Asset utilization did decline to 1.2x in the latest 12-months from 1.4x reached in fiscal 2005. Apple has been delivering high quality profitability.
Focus on companies where return on equity is outperforming. Compare companies in the same industry over several years to find the company that is delivering a quality return on equity that is higher than its competitors and improving at a comparatively favorable rate.
What is the earnings growth rate that a company can sustain in the long-term? After dividends are paid to shareholders, the remaining income is retained and reinvested in the business. This is the earnings retention ratio ((net income – dividends) / net income), which is the opposite of the dividend payout ratio. The return on equity is the rate at which these earnings are reinvested:
Sustainable Earnings Growth Rate = Earnings Retention Ratio X Return on Equity.
Apple’s return on equity was 27.6% in the latest 12-months. The company does not pay a dividend, and therefore retains all of its earnings. The long-term sustainable earnings growth rate is 27.6% (1.00 X .276), assuming these variables remain constant. Apple’s earnings are growing rapidly, up 46.5% in fiscal 2006 and 76.5% in the latest 9 months. Supported by Apple’s ability to successfully change and lead markets with innovative products, the company’s earnings may continue to grow at this fast pace for a while. But in the long run, earnings growth will reflect the company’s sustainable growth rate.
Return on equity can be a useful valuation metric. The stock price is the market value of your ownership in the business. One way to value stocks therefore is to divide the stock price by book value per share (common shareholders’ equity / shares outstanding). Going a step further and dividing price to book value by return on equity gives added perspective by placing this valuation measure within the context of a company’s profitability.
Dividing Apple’s price to book value per share of 8.5x by return on equity of 27.6% gives .3080. Performing the same calculation for the industry (7.1x / 38.1%) and the S&P 500 (4.0x / 21.3%) yields .1864 and .1878, respectively. Based on these comparisons, investors are expecting both Apple’s book value and return on equity to grow substantially faster than the industry and the S&P 500, and therefore are awarding Apple’s shares a premium valuation.
