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Return on Equity

Robert D. Gibb

The most commonly known evaluation tool for stocks is the PE ratio. This is simply the current price of a share divided by its annual earnings. Bank of Montreal (TSX: BMO) has a current price of $54.31 and earnings of $3.22 per share. Its PE ratio is $54.31 divided by $3.22 equals 16.87.

Problems occur when comparing PE ratios among companies. Many money managers expect PE ratios to be fifty percent higher than the growth rate of a company. If this is true the expected growth rate for BMO would be 11.25%. At the same time a company with a projected growth rate of 30% could be expected to have a PE ratio of 45. PE ratios as an evaluation tool are most valuable when comparing companies with similar growth rates.

Another problem with the PE ratio is that it fails to account for profitability on sales. Did BMO produce $3.22 of earnings on ten dollars of sales, on one hundred dollars or some other value? Higher earnings per sale (profitability) create happier investors. The PE ratio just doesn’t give us a sense of company profitability.

One measure of profitability is Return on Equity. ROE is net income divided by shareholders equity:

ROE = Net Income/Shareholder’s Equity

Expressed as a percentage ROE gives a picture of the relative profitability of a company. Investors like companies to have a minimum ROE of fifteen percent. That is, the company is earning at least fifteen cents for every dollar the company is worth.

There is a limiting factor in relying on ROE as an evaluation tool. Shareholders equity equals assets (what the company owns) minus liabilities (what the company owes):

Shareholder’s Equity = Assets – Liabilities

Shareholder’s Equity on a per share basis is known as book value. Return on equity becomes:

ROE = Net Income/ (Assets – Liabilities)

Suppose we have a company that has two dollars income on every twenty dollars in assets and ten dollars in liabilities. The ROE would be:

ROE = $2/ ($20 - $10) = $2/ $10 = 20%

However, suppose liabilities are increased through borrowing to fifteen dollars. 'Owner’s equity has not changed and remains the same at $10. However, assets have now increased to $25. After borrowing the new equation would be:

ROE = $2/ ($25 - $15) = $2/ $10 = 20%

Profitability as measured against shareholder’s equity was not changed by increasing debt. This is the limiting factor: increasing debt would not appear to affect return on equity. Recognize though that as liabilities and debt increase net income is likely to drop due to increased debt servicing.

Regardless, when using ROE to evaluate DRIPs it is important to keep an eye on debt levels. A smart investor wants a high return on equity coupled with low levels of debt. One rule of thumb is to look for companies with debt to equity ratios of 0.50 or less.

Let’s take a look at the ROE of Canadian DRIPs as of 31 December, 2003:

Return on Investment for Canadian companies offering DRIPs with optional Stock Purchase Plans (SPP)

Company (TSX Symbol)

ROE

Debt/Equity

Alcan (AL)

4.32

0.39

Aliant (AIT)

11.55

0.75

Bank of Montreal (BMO)

16.28

0.27

Bank of Nova Scotia (BNS)

17.76

0.19

BCE (BCE)

18.11

1.17

CIBC (CM)

19.15

0.31

Dofasco (DFS)

6.51

0.25

Emera (EMA)

6.65

1.24

Enbridge (ENB)

20.08

1.76

Fortis (FTS)

12.24

1.67

Imperial Oil (IMO)

25.35

0.14

IPSCO (IPS)

1.57

0.39

MDS Health (MDS)

3.45

0.40

Molson (MOL)

28.31

0.88

National Bank (NA)

16.36

0.43

Suncor (SU)

28.25

0.64

Telus (T)

-3.50

1.01

Terasen (TER)

10.20

1.72

Transalta (TA)

9.43

1.15

TransCanada Corp (TRP)

13.37

1.54

What jumps out quickly is that many Canadian DRIPs have debt to equity ratios well above 0.50. However, many Canadian DRIPs are utilities and higher debt levels are to be expected.

It is more interesting to compare similar companies here in regards to profitability and debt levels. For a simple comparison I’m dividing the ROE by the Debt to Equity ratio here.' Let’s look at the banks. CIBC has the highest ROE at 19.55 percent while Bank of Montreal is lowest at 16.28 percent. When we divide both by the debt to equity ratio we get approximately 60 for both. It would seem the market values both of these companies similarly. However, when we divide the ROE of the Bank of Nova Scotia by its debt to equity ratio we get a number closer to 90. While the ROE for CIBC is higher, BNS is showing a high return on significantly less debt. This is a measure of management’s efficiency in handling debt and one of the reasons some analysts see BNS as the leading growth opportunity among the big six Canadian banks.

Robert Gibb, 106-1217 Pandora Avenue, Victoria, BC, V8V 3R3 (250) 383-7075 [email protected]. Robert Gibb is a retired school teacher. He gives seminars on dividend reinvestment plans. Mr. Gibb is a frequent contributor to Internet DRIP boards under the nickname OperaBob.