Master Return on Tangible Equity (RoTE): A Comprehensive Metric to Measure Performance

What is the return on tangible equity (RoTE), and how can it help you make better investments? Is the return on tangible common equity (RoTCE) yet another one of many metrics in the world of stock investment (Return on Equity, Return on Common Equity, etc.), or is it actually worth your while? Well, there’s only one way to find out.

This blog post will tell you what really matters about RoTE without the extra info you don’t need. Learn what it is, why it matters, and how to calculate and use it to make your investments successful.

What Is Return on Tangible Equity?

Return on tangible equity (RoTE) refers to a percentage with which a company’s performance efficiency is evaluated. It basically shows the amount of income a company has managed to earn only using the tangible equity of common shareholders. As a result, the RoTE is also often referred to as “return on tangible common equity,” or RoTCE, for short.

The RoTE focuses on the part of shareholder equity that’s been separated from preferred equity and intangible assets like goodwill and patents. The tangible common equity (TCE) itself is a measure of the company’s financial strength, showing the dollar amount the common shareholders would receive if the company were to liquidate today.

RoTE Vs. RoE

One of the most common questions we get when it comes to return on tangible equity (RoTE), is how it’s any different from the usual return on equity (RoE)?

To start with, while RoE focuses on the entire equity under the firm’s position, RoTE only takes tangible equity into account.
Next, you should know that RoTE is mostly used in capital-intensive or intangible-heavy industries, while RoE is used across broader sectors. Additionally, RoTE helps investors better make informed decisions by silencing the intangible “noise”. However, that’s not the case for RoE.

Why Does Return on Tangible Common Equity Matter?

Let’s first take a step back. Why would TCE matter in any context?

The fact of the matter is that intangible equities are subjective and prone to drastic changes. They may not play as big of a role in the firm’s revenue generation as tangible equities, which brings us to RoTE once more. In simple words, the return on tangible common equity gives you a clearer picture of the firm’s capital efficiency.

But how do I even use RoTE?

Excellent question! There are three major facts you need to pay attention to when it comes to the importance of RoTE. First and foremost, investors can use the metric in their analysis of companies, determining if the company delivers sufficient returns on its core equity, minus the influence of intangibles, that is.

Aside from that, the metric is a great tool for comparisons. Especially if you’re thinking of two or more companies that differ drastically in the amount of their tangible equity.

Last but not least, RoTE is a great tool for evaluating banks. Generally, the banking system allocates a major part of its equity to intangible assets, which could falsely inflate its ability to generate returns while accounting for the tangible capital base.

Return on Average Tangible Common Equity Formula

For the return on tangible equity, calculations are pretty straightforward. All you gotta do is divide the net common income by the common tangible equity, which creates the formula below:

Where:

• Net Income: The company’s earnings after taxes, found on the income statement.
• Preferred Dividends: Dividends paid to preferred shareholders (if any).
• Tangible Common Equity: Total equity available to common shareholders, excluding intangible assets and goodwill. It’s available on the company’s balance sheet

Of course, you will also need to calculate the TCE. But don’t worry; it’s just as simple as RoTE’s formula, if not easier.

Example of Return on Tangible Equity (RoTE)

Now it’s time for a good example to get all the math work and formulas to actually stick. Let’s assume a company has the following details:

Net Income: $100 million
Preferred Dividends: $10 million
Total Equity: $1 billion
Goodwill: $200 million
Intangible Assets (excluding goodwill): $100 million

Your first step here would be to calculate the net income after preferred dividends are paid.

Net Income = $100 million – $10 million = $90 million

Then, you can go ahead and start on your TCE, which is determined as shown below:

TCE =$1 billion – $200 million – $100 million = $700 million

Next, you can calculate your RoTE according to the formula:

RoTE = $90 million $700 million = 12.86%

Simply put, the company generates $12.86 for every dollar of its tangible equity.

What Impacts RoTE?

The two most obvious answers to this question are net income and tangible common equity, as they are both in RoTE’s equation. As expected, a higher income would increase the final RoTE percentage. At the same time, if the TCE increases for any reason and the net income doesn’t “match the vibe,” it would dilute the metric.

Aside from these two, leverage should also be considered. This means firms with more debt and less equity might show elevated RoTE due to reduced equity. Lastly, you should also pay attention to intangible write-offs. For example, a significant goodwill impairment could artificially inflate RoTE by reducing the denominator.

Advantages and Disadvantages of RoTE

While RoTE is an amazing index of financial strength and capital efficiency, it’s not perfect either. Below is a list of pros and cons you can consider.

Wrap-Up

Return on tangible common equity (RoTE) helps investors compare their investment options and analyze their current dedications by providing a numerical measure of the company’s capital efficiency. In other words, it shows investors how much money a firm makes for every dollar of their tangible equity.

The formula for return on tangible equity is super simple to follow, dividing the net common income of the firm by its tangible common equity. Due to the omission of intangible assets, RoTE becomes a more accurate, clearer metric for analyzing company performances.

Still, other factors should also be considered for optimum results. There’s no ending point to the vast world of stock market and succeeding in this world requires up-to-date knowledge, patience, and resilience. To get ahead of the game and learn more about concepts like return on tangible equity, you can follow our blog and youtube channel for the latest trading tips and secrets, open a demo account to test your trading plans and trade with discipline to master that patience we went over.