Financial performance ratios
A company's financial performance ratios will give you an idea of how efficient its management is at making the most of the capital and assets at hand.
Return on equity
A company's return on equity (ROE) helps you gauge its ability to turn money invested in it into profits.
ROE is calculated by dividing a company's net income by its total outstanding equity over that period and multiplying the figure by 100. It is presented as a percentage:
ROE = (Net income/outstanding equity) x 100
For example, a company that made a net profit of £5 million in its first quarter and had £100 million worth of shares outstanding over that period would have made a return on equity of 5% for that quarter.
If the company's ROE is low – even if it has posted record headline profit – it suggests that management is not reinvesting its earnings efficiently.
This could hinder the company's future growth prospects, making its shares less attractive and pushing down their price.
In theory therefore, the higher a company's ROE, the better investment opportunity its shares represent.
Do not take the ROE at face value
There are a number of factors, however, that can distort a company's ROE and these should be considered before you buy or sell shares based on the ratio.
For example, if a company buys back a lot of its shares, this will reduce the value of its outstanding equity and push up its ROE, creating a "buy" signal that might not be justified.
Return on capital employed
A company's return on capital employed (ROCE) is calculated by dividing its earnings before tax and interest (EBIT) by its total capital employed (both outstanding equities and debt). It is expressed as a percentage:
ROCE = (Earnings before tax and interest/total capital employed) x 100
It is similar to return on equity apart from the fact that debt is now added to a company's shareholder equity to reach a "total capital employed" figure. This makes it a slightly better measure of how well a company generates returns from its available capital.
A ROCE figure higher than average borrowing rate is desirable
As a rule of thumb, look for a ROCE that is equal to or higher than a company's average borrowing rate. This suggests that a company is a solid investment, and might encourage you to buy its shares.
A ROCE that is lower than a company's average borrowing rate could put downward pressure on its share price and on shareholder earnings.
For example, if a company has earnings (before tax and interest) of £800,000, debt liabilities of £200,000 and shareholder equity of £5 million (ie total capital employed of £5.2 million), it will have a ROCE of 15.4%.
If its cost of borrowing averages 7%, this company would make a good investment choice, based on its ROCE.
Return on assets
A company's return on assets (ROA) shows you how much money in earnings a company derives from each unit (£1, $1, €1 etc) of assets that it owns. This gives you an idea of how efficient the company is at turning what it owns into profit.
ROA is calculated by dividing a company's net income by its total assets and multiplying this figure by 100. It is expressed as a percentage:
Return on assets = (Net income/total assets) x 100
Different industries have different standards
A high ROA is generally preferable when you are looking for shares to buy.
Different industries tend to have widely differing ROAs, meaning it is not advisable to use this ratio to compare companies in different sectors.
Some industries are by nature more capital intensive than others – telecommunication providers, for example, will need lots of heavy equipment to turn a profit, while an advertising agency relies more on intangible assets like brand or intellectual property.
This means a poorly performing advertising agency could misleadingly appear a better investment based on its ROA than a well performing telecom company.
Compare companies within the same sector
It is best therefore to use this gauge to compare companies in the same sector.
For example, if auto maker A has a net income of £1 million and total assets of £10 million, its ROA would be 10%. If you compare this with auto maker B, its net income of £1 million and total assets of £20 million give it an ROA of 5%.
All things being equal, company A represents the best investment for a shares trader. This is because the company's management is doing a better job of doing what companies are all about – turning capital into profit.
You can also use it to look for performance trends at one company – examining its historical ROA and how it is changing. If it ROA is falling, this could encourage you to short its shares.
In this lesson, you have learned that...
- … a company's financial performance ratios give you an idea of how efficient its management is at making the most of the capital and assets at hand.
- … the return on equity (ROE) ratio helps you gauge a company’s ability to turn money invested in it into profits.
- … the ROE, however, can be distorted. For example by a share buyback, after which the ROE can produce an unjustified "buy" signal.
- … the return on capital ratio is similar to return on equity apart from the fact that debt is now added to a company’s shareholder equity to reach a "total capital employed" figure.
- … it measures how well a company generates returns from its available capital.
- … when buying shares, look for a return on capital employed that is equal to or higher than a company's average borrowing rate.
- … the return on assets ratio shows you how much money in earnings a company derives from each unit (eg £1) of assets that it owns – this gives you an idea of how efficient it is at turning what it owns into profit.
- … you can use it to compare companies in the same sector or to look for performance trends at one company.