What is Return on Equity?
Return on Equity (ROE) is a financial performance metric that measures a company’s return on its net assets. The formula for calculating the ROE of a business is the net income of a business divided by its net assets (or shareholder equity). A high ROE for a business as measured against others in its industry is a sign of significant competitive advantages resulting in a more efficient use of its capital. Some businesses may be in low capital-intensive industries requiring a lower amount of net assets to generate a similar level of profits compared to other industries. A low capital intensive industry will have businesses with high ROE since less capital is needed to sustain and grow profitability. Many business owners are unaware that they have a high ROE business, which supports a premium business valuation when it comes time to sell.
High ROE Businesses More Valuable
Businesses with high ROE require less capital to grow or sustain itself over the long term. This allows the business owner to keep more of the profits compared to businesses with a low ROE. A sustainably high ROE may also lead to a virtuous cycle where profits are prudently reinvested in the business (by adding to shareholder equity) at a similarly high rate of return. It is helpful to note that shareholder equity is a company’s total gross assets minus its liabilities or debt. Total gross assets comprises current assets (can be converted to cash within a year) and non-current assets (can not be converted to cash within a year). Current assets include cash, accounts receivable (A/R), and inventory. Non-current assets include tangible assets such as property, plant, and equipment along with non-tangible assets like patents and goodwill. The less capital needed for a company’s net assets, then the higher Return on Investment (ROI) a buyer will have when purchasing the business.
Illustrating ROE Impacting Business Sales
- Let us analyze two businesses with markedly different ROEs and see how this difference impacts their respective business valuations.
- Nora’s Nurse Registry is a home healthcare business which services patients in their homes.
- It uses almost no equipment (and hence has little if any non-current assets), and its working capital amounts to $200K of A/R.
- With $50K of accounts payable (or liabilities), Nora’s Nurse Registry’s shareholder equity is $150K ($200K – $50K).
- Nora’s Nurse Registry generates $300K/yr of net profits, and thus has an outstanding ROE of 200% ($300K / $150K).
- Now let’s examine the ROE of Wayne’s Wholesale Distributors which is a distributor of perishable goods to local convenience stores.
- Unlike Nora’s Nurse Registry, Wayne’s Wholesale Distributors requires a large amount of capital to sustain its operations.
- This includes working capital of $750K for inventory and A/R, as well as $750K for equipment and vehicles necessary to pack and distribute its inventory.
- Since Wayne’s Wholesale Distributors has $50K of accounts payable or liabilities, it’s net assets or shareholder equity is $1.45M ($750K + $750K – $50K).
- With an identical $300K of net profits as Nora’s Nurse Registry, note how Wayne’s Wholesale Distributors has a markedly lower ROE of 21% ($300K / $1.45M) compared to an ROE of 200% for Nora’s Nurse Registry.
- What do the two different ROEs tell a buyer about these two businesses?
- First, the home healthcare industry is naturally less capital-intensive than a wholesale and distributor business.
- Home healthcare companies generally require little or no inventory and equipment to sustain its operations (although it does require A/R since healthcare companies bill in arrears).
- Next, the high ROE of Nora’s Nurse Registry shows that it needs very little capital to grow its business.
- If Nora’s Nurse Registry decided to expand its operations by marketing in a different region, obtaining more referral sources, and adding more labor, it would not need to deploy much more capital into the business (other than A/R).
- In contrast, if Wayne’s Wholesale Distributors decided to expand its operations in an effort to generate more profits, it would likely need to deploy a substantial amount of capital in order to purchase more capital equipment and carry more inventory.
- While a buyer of Wayne’s Wholesale Distributors may increase its profits, they could not increase its ROE in the long term given the capital requirements of the industry.
- Lastly, Nora’s Nurse Registry should have a superior growth rate over time compared to Wayne’s Wholesale Distributors.
- So long as Nora’s Nurse Registry sustains a high level of ROE and prudently redeploys a modest amount of capital to shareholder equity (such as carrying more A/R), its net profits will rise.
- These key differences result in a higher business valuation for Nora’s Nurse Registry compared to Wayne’s Wholesale Distributors.
High ROE Protects Against Inflation
Inflation – or the devaluing of the dollar resulting in a rise in prices – adversely affects low ROE businesses with a large amount of inventory, capital equipment, and accounts receivable. In an inflationary environment, businesses with low ROE face higher costs when maintaining or expanding its net assets. In contrast, businesses with high ROE maintain and require less shareholder equity, and do not have to spend as much capital to maintain or expand its net assets. Moreover, high ROE businesses generally have strong pricing power typified by strong operating margins. By having the ability to raise their prices charged to consumers, high ROE business can protect their operating margins better than low ROE businesses (which are less efficient and have lower operating margins) in an inflationary environment.
When selling a high ROE business, it is imperative that the business broker understand why the business has a high ROE, and how this justifies a premium purchase price. A business that generates a high return on its net assets over the long run will require relatively less working capital and capital equipment. This ultimately puts more money in the pocket of the business buyer and increases their return on investment. A business that can deploy a good amount of its profits into its shareholder equity while sustaining a high level of ROE also benefits from a virtuous cycle of long term growth.
Give Martin at Five Star Business Brokers of Palm Beach County a call today at 561-827-1181 for a FREE evaluation of your business.