Return On Equity - ROE

See: Return on Assets.

Well, when you go to a fancy sushi bar, those little orange eggs cost a small fortune. They come from libertarian salmon and taste just like salt licked from your grandmother’s purse. So that’s ROE. But it has nothing to do with that kind of ROE, or Return on Equity.

So very simply, any time you see a ratio that’s Return on anything, it means profits in the numerator sitting on something in the denominator. Like...return on sales is a company’s profit margin. Right? You have profits divided by sales, and that’s a pretty easy calculation to make if you have the data.

Return on Equity is a bit different, in that finding what you mean by equity is sometimes a bit of a moving target, or a religious discussion in the way the equity line on the balance sheet was, in fact, calculated. In essence, the equity of a company is what it owns. It’s the equity value of the firm. Like...the cash profits it has generated over time, or the cash it has received from investors, plus fair value of its patents and brands and distribution infrastructure, and 18 zillion other elements that add together to comprise whatever number is placed as the equity of the firm. So then the ROE for your lemonade stand, with 12 grand in profits, and equity of 36 grand, is ⅓, or 33%.

Is that good? Bad? Ugly? Well, in a vacuum, we don’t really know. Because each industry commands such different kinds of numbers when it comes to the efficient use of its equity. A lemonade stand needs relatively very little capital to get started. It should have very high returns from its equity, because its profit margins should be very high when it’s selling for a dollar-something that costs it a dime.

You can think of the 33% return as being something that might map to investing in a stock market reflective index fund. And yes, 33% a year return from any kind of stock market investment over time is a heroic score. The problem? The return number is likely highly volatile in a company with such massive return on equity. That is, yes, this year your little lemonade stand made 12 grand, but next year it might lose 5. The following year it might make 20, and the following year, go bankrupt. So the ROE number for a company so fragile, like Lemonade Stands R Us, is on the edge of meaningless.

Compare the ROE for a large oil company. Oil is massively less volatile as an industry than your lemonade stand. And 20 billion dollars just buys you a well, some storage tanks, a little distribution infrastructure, and hopefully a decent line to getting your money back. So if you measured the return on equity of a given oil company over a 10-year cycle, you might find that its return is only 4.5%. That equity could have been deployed almost certainly in the investing community...and done much better than what the managers of the oil company did in putting all that money in the ground through wells and exploration and refining, and so on. So, as an unschooled investor, you might begin to be leaning on management to take their cash and do something else with it.

Then, one day, a bomb goes off in the Middle East. A big one. Oil prices go from 50 bucks a barrel to 100, and for the following decade, the ROE of the oil company looks a lot more like the 33% from the lemonade company, and the investor who pushed Shell to fund a Google competitor goes back to work at Bank of America, trading four fives for a twenty, and pushing customers to refi their mortgage.

The bottom line is that ROE is a moving target at best, and only exists in the vague nether land of time, in that, contextually, it only means something when mapped against a whole host of other things players could do with their money. So if your company’s trying to stay above water, and you start smelling something fishy, it, uh, might just be the ROE.