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Investing
Chief ratios for stock hunters - part 2
Nick Renton AM - August 27, 2007
 In an article last month Nick Renton walked through the return on assets (ROA) ratio - this month he explains the return on equity.
The return on equity (ROE) is a measure of the efficiency of a company. It can be used by security analysts to complement the use of other yardsticks. The ROE is defined as the ratio obtained by dividing a company's profit (net of preference dividends, if any) by the shareholders' funds (net of preference capital and intangible assets, if any), expressed as a percentage.
The shareholders' funds are often referred to as the equity in a company. By definition, the equity equals the company's net assets, that is, its gross assets less its liabilities.
Another measure of efficiency is the return on assets (ROA). It is defined as the ratio obtained by dividing a company's earnings before interest and tax (EBIT) by the gross tangible assets, expressed as a percentage.
These ratios are very much affected by the level of gearing. The figures in Table 1 show how to calculate the ratios and they also demonstrate the effect of changes in the gearing ratio (liabilities as a proportion of equity).
To aid understanding, these hypothetical figures show a deliberately simplified picture, to the extent that the liabilities are all treated as interest-bearing, which, of course, is not the case in practice.
Case A shows one set of assumptions. Case B shows the effect of a slightly higher earnings rate and Case C shows the effect of a slightly lower interest rate.
It will be noticed that at low gearing ratios the ROE is lower than the ROA. At high gearing ratios the reverse applies.
Table 2 shows the ratios for five very different companies selected at random, as derived from their latest annual reports. End-of-year figures have been used, although theoretically weighted average assets figures for the year would have been better.
The figures shown for Coles (CGJ) are probably not typical, because of the company's disposal of the Myer stores during the year.
Two practical points for those wanting to do their own calculations: For companies with minority interests the calculations need to use the equity including these interests, not the lower equity of the shareholders in the listed parent company. The interest paid figure can usually be found in the notes to the accounts.
More articles from this week's newsletter:
Markets: Trouble in China has investors guessing
Self-managed super: Old strategies are now even better
Sustainable investing: Climate change and consumers: hot air or real deal?
Fundamental analysis: Chief ratios for stock hunters - part 2
Resident Trader: Trading CFDs in a gapping market
Smart Investing: Experience tunes in to the market blues
Analyst report: Retail in a tailspin?
US markets: Long valuation waves and market fear
Sub-prime: Sub-prime what?
Ask the expert: Uncovering the average forex trader
Stock of the week: Mincor shares suffer from nickel freefall
CFDs: Pyramiding provides windfall to CFD traders
CompareShares Reader: Cloud gazing or tea leaves?
Whatever your views, you can discuss this article - or any of Nick's articles - on our message board Your 2 Cents.
Nick Renton AM is the founder and first president of the Australian Shareholders' Association. He is a consulting actuary, commercial arbitrator, company director and writer. He is the author of 62 published books covering shares, property, managed investments, taxation, wills, the Internet and the Australian economy. He has written books about more different topics than any other Australian author. He was made a Member of the Order of Australia in 2004.
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