It measures of the profitability of a business in relation to the book value of shareholder equity. It is generally expressed by the ratio of net profit to shareholders' equity. An average of 20% or more return on equity is preferable. The company that earns high returns on equity usually requires paying a high premium price compared to its book value. The following example would make it clearer.

It measures of the profitability of a business in relation to the book value of shareholder equity. It is generally expressed by the ratio of net profit to shareholders' equity. An average of 20% or more return on equity is preferable. The company that earns high returns on equity usually requires paying a high premium price compared to its book value. The following example would make it clearer.

Suppose you have Company A with net tangible assets (book value) of $10 million. The company is making $4 million net profit on its net tangible assets; incidentally, it produces a return on equity of 40% ($4 million/$10 million * 100). The company’s owner wants to sell his business and asks a price of $32 million, eight times the multiples of its current earnings or $22 million more than its net tangible assets.

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Now, let’s say we have another Company B with net tangible assets (book value) of $20 million, making $4 million of net profits on its net tangible assets. Thus, it is producing the return on equity of 20% ($4 million/$20 million * 100). The company’s owner also wants to sell his business and asks a price $32 million, eight times the multiples of its current earning or $12 million more than its net tangible assets.

Now, let’s say we have another Company B with net tangible assets (book value) of $20 million, making $4 million of net profits on its net tangible assets. Thus, it is producing the return on equity of 20% ($4 million/$20 million * 100). The company’s owner also wants to sell his business and asks a price $32 million, eight times the multiples of its current earning or $12 million more than its net tangible assets.

Let’s say both these companies want to double their earnings to 8 million, and to do so, they require the doubling of their investments in their net tangible assets too. To double the production output, you require investing lot more in inventory, plants, and machineries. To achieve this, Company A only requires an additional $10 million in capital added to its net tangible assets, whereas Company B requires the addition of $20 million more to produce the same amount of earnings, $8 million. This makes Company A more valuable compared to Company B, since the infusion of up-front capital costs are quite low (only $10 million) compared to the $20 million to produce an additional $4 million in earnings. Therefore, you may pay $32 million, or 8 times the multiple of its current earning, to acquire the business from the owner of Company A but would only pay about $20 million, or 5 times the multiple of its current earnings, to acquire the business from the owner of Company B.

In short, whenever you see a company that constantly produces high returns on its net tangible assets or equity, don’t hesitate to pay a little bit more to acquire the business or stock.

Checkout our ROE based stock value filter.

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