Return on equity- an important metric

The return on equity is a very important metric. Why? It can be decomposed into a formula equating to = sales/assets x net income/sales x assets/equity

Sales/Assets is the asset turnover. It is the sales generated with a fixed amount of asset base. You would want this figure to be higher than industry average as you would expect the company to maximise its assets that it has. The best case scenario in this case is high sales over low asset base. An example of such a company i would presume is a company such as See's candies. It has a low asset base and relies heavily on its intangibles to deliver a high ratio. Warren Buffet would like his companies to have strong brands for the value of a brand is priceless. Therefore, in actual fact, See's candies has a low asset base and and relatively larger portion of intangible assets which cannot be accounted for in this ratio.

The 2nd component of return on equity is the profit margins. You would want the profit margins to be higher than industry average. This would show that the company has a certain moat to it.


The case is that high profit margins and high sales turnover would magnify your return on equity. The other reason why an investor should focus on this number is that if you did invest in equity of the company, this is the metric that will tell you your returns as an investor. The higher the number, the better without an increment in debt. Beware though for all a company has to do to boost this number is take on loads of debt for that will reduce the equity base and cause the return on equity to be higher than normal. Hence, it would thus make sense to me to look at the return on equity historically for at least the past 5 years.

Cheers,
Lucas