Return on Tangible Equity

What is Return on Tangible Equity?

Return on tangible equity (RoTE) is a metric used to assess a company’s performance. It is most frequently used by analysts when analyzing financial institutions, such as banks and insurance companies.

RoTE is calculated using the following formula:

Tangible shareholders’ equity = Ordinary shareholders’ equity – goodwill – other intangible assets, with equity and asset values reflecting amounts reported in the balance sheet.

Although RoTE is usually calculated using the average value of tangible shareholders’ equity, it can also be calculated using opening tangible shareholders’ equity.

RoTE helps us understand the earnings generated for equity investors relative to the amount of equity capital, net of intangible assets. Therefore, it can be used to assess how efficiently management is allocating shareholders’ funds across the business or help predict the future profits that the company will generate.

Tangible Equity vs. Shareholders’ Equity

Analysts typically use both return on tangible equity and return on shareholders’ equity for assessing the performance of banks and insurance companies. So which metric gives a better measure of performance? The answer is…it depends!

Return on shareholders’ equity is a more comprehensive measure of performance as it includes all shareholders’ equity used by management for investment in the business. Therefore, return on shareholders’ equity is a helpful metric when appraising management’s historic investment decisions.

However, adjusting the capital measure to exclude intangible assets has two benefits; firstly, this is more consistent with how regulatory capital is calculated. So, RoTE allows us to assess how efficiently management allocates their regulatory capital base. Secondly, the goodwill generated during acquisitions is not subject to amortization, so acquisitions typically inflate total equity and suppress return on equity. If we exclude intangible assets from equity, it is easier to compare acquisitive companies with peers who have grown organically.

Calculating Return on Tangible Equity

Financial institutions often disclose RoTE in their financial statements, as their management widely uses this metric as a key performance indicator. However, they sometimes make proprietary adjustments to profit or shareholders’ equity calculations.

Analysts sometimes calculate the metric themselves to ensure that they have a consistent ratio that can be used to compare peer banks.

Below is an extract from a bank’s financial statements:

Extract from HSBC’s Financial Statements for the year ended December 31, 2021

We note the following two important points from the given extract:

Firstly, the total profit attributable to ordinary shareholders in 2021 was $12,607m. This was adjusted to exclude goodwill impairments and the change in the value of insurance contracts (“PVIF”), resulting in adjusted profit attributable to ordinary shareholders of $13,157m. This is a significant increase in adjusted profits in 2020, due to the effects of the covid pandemic in 2020.

Secondly, the average ordinary shareholders’ equity was $176,481m.  This was adjusted to exclude goodwill, other intangible assets, and the value of insurance contracts, resulting in average tangible equity of $158,776m. This is a 5.8% increase compared with 2020.

We can use this information to calculate the bank’s return on average tangible equity, 8.3% in 2021, compared with 3.1% in 2020. This improvement was due to the coronavirus pandemic suppressing profits – and therefore the RoTE – in 2020.

Example

Based on the information below, we are asked to calculate RoTE for ABC Bank and XYZ Bank in 20X1 and use this to compare their performance.

The information shows that XYZ Bank generated higher profits than ABC Bank in 20X1, but also that XYZ Bank also had a larger capital base than ABC Bank. It also appears that ABC Bank has been more acquisitive than XYZ Bank, as intangible assets are more significant relative to shareholders’ equity.

This makes it very difficult to compare the banks’ performance simply by looking at these numbers.

However, when we calculate RoTE, we can get a clearer view of how they compare:

ABC Bank has generated a higher RoTE than XYZ Bank.

This suggests that ABC Bank’s management is more efficient in their capital allocation, as they generate more profit for equity investors relative to their tangible equity base.

Download the accompanying Excel files to practice these calculations yourself.