The Difference Between ROE and Return on Tangible Equity

How do you measure the true profitability of a business? This is one of the most crucial questions investors ask themselves when considering where to place their capital. Two of the most widely used metrics for this purpose are Return on Equity (ROE) and Return on Tangible Equity (ROTE). Though they may seem similar, these two metrics offer unique insights into a company's performance. But what exactly sets them apart?

Let’s take a deep dive into both metrics, their definitions, and their practical applications.

Return on Equity (ROE)

ROE measures a company’s ability to generate profits from its shareholders’ equity. Simply put, it shows how effectively the company uses the capital invested by shareholders to generate earnings. It is calculated using the following formula:

$ROE=\frac{NetIncome}{Shareholde{r}^{\prime }sEquity}$ROE=Shareholder′sEquityNetIncome​

Here’s an important point: shareholder's equity includes everything on the company's balance sheet, including intangible assets like goodwill, patents, and trademarks. Intangible assets can be tricky. They are not physical and often hard to value, yet they make up a significant portion of many companies' assets, especially in sectors like technology and pharmaceuticals.

Return on Tangible Equity (ROTE)

ROTE, on the other hand, strips away these intangibles, providing a more conservative measure of a company’s equity. It looks at the company’s net tangible assets—what would be left if all intangible assets were written off. This is the formula for ROTE:

$ROTE=\frac{NetIncome}{TangibleShareholde{r}^{\prime }sEquity}$ROTE=TangibleShareholder′sEquityNetIncome​

Tangible shareholder's equity is essentially shareholder's equity minus intangible assets. By focusing on the tangible equity, ROTE gives a more grounded view of how well a company is utilizing its "real" capital—i.e., assets that have actual, physical value.

Why the Difference Matters

Both ROE and ROTE aim to measure profitability, but they do so with different perspectives. ROE includes intangible assets in its calculation, which can overstate the profitability of a company that has significant goodwill or intellectual property. ROTE is more conservative and is often used by investors who are concerned about the tangible worth of a business, excluding the potential volatility of intangible asset valuations.

Consider this: if a company has a large amount of goodwill on its balance sheet, its ROE may look appealing, but its ROTE could reveal a less attractive picture. Goodwill is often an inflated or subjective figure, reflecting the premium paid for acquisitions, rather than the operational efficiency of the company. By eliminating intangibles, ROTE focuses on how well a business is performing using hard assets, rather than goodwill, patents, or trademarks.

Practical Application of ROE and ROTE

Let’s take two companies—Company A and Company B. Both have the same net income and shareholder equity. However, Company A has substantial goodwill on its balance sheet due to a recent acquisition, while Company B has a more "clean" balance sheet with fewer intangibles.

• Company A:

  • ROE: 15%
  • ROTE: 9%

• Company B:

  • ROE: 12%
  • ROTE: 12%

At first glance, Company A seems more profitable, with a higher ROE of 15%. However, its ROTE is significantly lower at 9%, revealing that much of its equity is tied up in intangible assets like goodwill. Company B, on the other hand, shows a more consistent return on both ROE and ROTE, indicating that it is generating a more reliable return on its tangible assets.

This distinction is particularly important when evaluating companies in sectors prone to large intangible assets, such as tech or healthcare, where intellectual property is a significant part of the balance sheet. Investors focusing on tangible value may prefer using ROTE to assess whether a company is effectively generating returns from its core operations and tangible assets.

Industries Where ROE vs. ROTE Plays a Big Role

In capital-intensive industries such as manufacturing, transportation, or utilities, tangible assets like factories, vehicles, and infrastructure dominate the balance sheet. In these industries, ROE and ROTE tend to be closer in value, since there is less goodwill or intellectual property to skew the figures.

On the other hand, in industries that are less dependent on physical assets, such as software companies, pharmaceuticals, or service-based businesses, the difference between ROE and ROTE can be stark. Companies in these sectors often have significant intangible assets, whether it's from patents, software development costs, or goodwill from acquisitions. As such, the ROE may appear strong, but the ROTE will reveal a more conservative outlook on their profitability.

For example, a tech company might boast an impressive ROE of 20%, but when intangible assets are removed, the ROTE might drop to 8%, suggesting that the company’s real, tangible profitability is far lower than its initial ROE suggests.

The Impact of Goodwill

Goodwill, often a major intangible asset, arises from acquisitions when a company pays more than the fair market value of the assets they are purchasing. While goodwill may reflect strategic benefits, such as synergies from a merger or brand strength, it can also distort profitability measurements like ROE. In contrast, ROTE offers a clearer picture by excluding goodwill from the equation, giving investors a better sense of the company’s ability to generate returns from its tangible resources.

In recent years, many investors have grown skeptical of goodwill on balance sheets, especially after seeing several companies write off huge amounts of it during economic downturns or following failed acquisitions. In this sense, ROTE is often considered a more prudent measure of a company’s financial health, especially in uncertain times.

Choosing Between ROE and ROTE

Which metric is better? The answer depends on the type of company you're evaluating and what you’re looking for as an investor. For businesses that rely heavily on intangible assets, ROE might tell a fuller story, giving credit to assets like patents or brand value. For companies with a strong focus on tangible assets, or for investors looking for a more conservative measure of profitability, ROTE offers a more grounded perspective.

Both metrics should be used in tandem to get a holistic view of a company’s financial performance. ROE can highlight the profitability of a company that has intangible assets, but ROTE will ground that view by stripping away those intangibles and focusing solely on tangible assets. Ultimately, both metrics have their place, and the choice between them should be guided by the specific industry and financial structure of the company in question.

In summary, while ROE is widely used, ROTE gives a more cautious and often more realistic view of a company's returns. Understanding the difference between ROE and ROTE can help investors make more informed decisions by clarifying whether a company’s reported profitability is driven by tangible or intangible assets.