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Return on Equity (ROE) indicates a company’s profitability by measuring how much the shareholders earned for their investment in the company. It exhibits how well the company has utilised the shareholders' money. ROE is calculated by dividing net profit by net worth. If the company’s ROE turns out to be low, it indicates that the company did not use the capital efficiently invested by the shareholders. Generally, if a company has ROE above 20%, it is considered a good investment.
An ROE above 15% - 20% is considered generally considered strong, though this should be evaluated in the context of the company's industry and peers.
Key Takeaways
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Return on Equity (ROE) is an indicator of how effectively a company utilises the funds provided by its shareholders to generate profits.
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A higher ROE is an indicator of better capital efficiency and profitability.
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It is important to compare ROE among companies in the same industry.
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While a high ROE is a good indicator of effective management, it should not be the sole consideration when making investment choices.
Also, read ROE vs Valuation here.
Why Is ROE So Important?
Return on equity is one of the essential ways to measure how profitable a company has been. Higher values mean the company is efficiently generating income on new investment. As an investor, you must learn to check and compare ROE of different companies before you make any purchasing decisions. It’s also a good idea to review trends in ROE over time for the companies in which you’re interested.
A word of caution for all investors is that they should not rely solely on ROE for investment decisions. The reason is that it can be artificially influenced by the management and hence not the most reliable of parameters. For instance, when debt financing is used to buy back shares and reduce shareholders' equity, ROE increases even if net income remains constant.
A good rule to follow for investments is to target companies whose ROE equals or is just above the average of competitors. For example, company NetCo Ltd. has maintained a steady ROE of 19% over the last few years, as compared to the average of its peers, which was 15%.
How Do You Calculate ROE?
ROE is an important metric for investors to evaluate profitable investment opportunities. Companies with higher ROE attract more investors, as it indicates they are better at retaining profit from shareholders’ equity. But how do you measure ROE, and what is a practical value to accept?
Investors calculate return on equity using the ROE formula, which gives a workable idea of the company’s profit generation.
ROE= Net Income/ shareholder’s equity
It is comparatively a simple formula to measure the merit of investing in a company. You can find net income in the company's income statement, representing the profit available after all expenses and before any dividends are distributed to shareholders. Sometimes analysts consider trailing income or income of the past twelve months to measure ROE.
Company’s net income is the value after subtracting COGS, SG&A, depreciation, amortisation, interest, and taxes from sales revenue. In the income statement, you can find net income at the bottom of the report, mentioned either as net income, net profit, or net earnings. Financial analysts sometimes use free cash flow value in place of net income to calculate ROE formula, but net income arguably is more accurate.
The next variable in the formula is shareholder equity, which is the difference between a company’s asset and liability. It signifies the amount left for shareholders if the company has to write off all its liability with its assets.
Return on equity or ROE is frequently used by investors and analysts, and it is quite popular. ROE formula helps to get a clear picture of financial and organisational profitability. Moreover, it is easy to calculate from the company’s financial statements. Net income is the most important item in the company’s financial statements. Similarly, a company’s balance sheet will tell the position of asset and liability. Companies release these statements periodically and keep available in the public domain for anyone interested.
What Is an Ideal Return on Equity (ROE)?
There is no universal benchmark for what constitutes an ideal return on equity, as it depends on the company's sector and business model. However, in general, a consistent ROE of more than 15-20% is considered strong for most industries.
Capital-intensive businesses, including manufacturing or utilities, may have a naturally lower ROE because of the greater asset requirements. Therefore, technology and financial companies tend to have higher ROE because they require less physical capital.
An ideal return on equity implies the ability of the management to generate profit from the shareholders' funds efficiently. However, a very high ROE (say more than 40%) could be misleading, particularly if it is due to high debt and not due to actual profitability.
Hence, investors should always consider ROE in conjunction with other key ratios, such as the debt-to-equity ratio, retained earnings, and cash flow performance, to gain a comprehensive view of the company's financial health.
Also, read What is Trading Account here.
Why Studying the ROE Formula is Significant?
A Study of the ROE formula reveals the merit of investing in a company. But it has several other applications. Here is why studying ROE is so important.
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Represents financial soundness: ROE tells you about the financial soundness of a company – strength of its financial and organisational framework. If a company boasts a higher return on equity, it signifies that the company is doing better than its peers in generating higher profit than shareholder equities. It is a positive indication for prospective investors.
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Helps to analyse company’s financial growth: Using ROE formula to calculate ROE at the different timeframe, one can draw a comparison in company’s financial growth. It reveals if the company exhibits steady growth or not. By comparing ROEs from different periods, investors can track the performance of the management.
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Comparing between companies: One limitation of ROE formula is that one can’t use it to compare between companies from different sectors. But it is still an excellent tool to determine performance between companies from the same domain.
Every sector has a median ROE, which one can calculate by averaging return on equities of all the companies from the sector. Using the average ROE as a base one can then compare performance between peer companies.
What Do Companies With High ROE Tell You?
ROE in the stock market is an indicator of a company’s performance and profit potential. Here’s how you can use this measurement tool to identify whether or not a company is worth investing in:
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Companies with high ROE know how to utilise shareholders money efficiently. If a company can produce high ROE regularly and consistently over time, it is a great idea to invest in such a company as the profits will only continue to grow due to the efficient management of money.
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Companies with high ROE are good at retaining earnings. Retained earnings is a source of capital for any business. When a company retains its earnings and reinvests them as working capital, it reduces the need for external debt financing, thereby minimising interest expenses. As an investor, you should check the company’s retained earnings every year and its return on equity the following year. If you see that the company has generated profits and ROE is increasing, it means that the company is generating revenues from the earnings it has successfully retained.
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Companies with high ROE have an advantage over its competitors in the sense that they can protect their long-term profits and dominate their market share without any hassle. Such companies can generate profits for a long-term and can reinvest gains to keep the cash flow going.
How to Use ROE in 3 Ways
1) To estimate sustainable growth - Using the ROE, it is possible to determine the sustainable growth rates and dividend growth rates of a company, provided that the ratio falls roughly in the same category or just above its peer group average. You can use the ROE to estimate the stock’s growth soon and the growth rate of its dividends. Compare these numbers to those of a similar company or companies to reach a fair evaluation of the estimates growth rates
2) Dividend Payments – If you’re contemplating investing in a company, a high ROE can tell you whether that company has enough capital to make shareholder payments. A high return on investment is a reliable indicator that the company has invested its capital optimally and is making profits that can be paid to the investors as dividends
3) The DuPont Formula – The DuPont model is a handy tool for many investors to arrive at a company’s ROE and break down the factors that result in high or low ROE.
The DuPont formula calculates ROE by comparing a company’s total profit margin against its sales turnover against its financial leverage. Here's the math:
ROE (Return on Equity) = (Net Income/Sales Revenue) X (Sales Revenue/Total Firm Assets) X (Total Firm Assets/Shareholder Equity)
While using this formula will generally give you the same result as the classic return on equity approach, this is more helpful for investors who want to break down a company's performance more clearly and understand the components working in its favour.
Can the ROE of a Company be in the Negative Values?
Yes. The ROE of a company can be so low that it falls in the negative digits. Usually, investors don’t calculate ROE for firms with negative net income. However, sometimes it so happens that the firm has negative shareholder equity due to liabilities that exceed assets at the time of positive net income returns. In a case like that, the ROE derived using the formula will be a negative value.
It is crucial to note that a negative ROE doesn’t mean that you should disregard the company altogether. However, it should be a warning for you to go ahead with great caution. In typical scenarios, a negative ROE would signify that the company has problems with debt, asset retention or both. Although, even these are not guaranteed indicators that you shouldn’t invest in said company. The negative ROE could be as a result of the company’s business development initiatives. When the company takes out a significant debt to launch an ambitious new project, it might end up with a negative ROE if the borrowed money is more than the company’s worth.
How to Interpret ROE?
Knowing ROE interpretation can help investors distinguish between truly profitable businesses and those that are merely leveraging financial resources.
Sometimes, companies may boost their ROE artificially by taking on additional debt. While this can temporarily enhance returns, it increases financial risk and can eventually erode net income. Thus, a consistent and moderate ROE over several years indicates stable profitability and good management. A sudden spike in ROE is not always good news, as it can be the result of lower equity from share buybacks or increased debt.
When comparing companies, ROE must always be viewed alongside other ratios such as Debt-to-Equity ratio, Net Profit Margin, and Earnings per Share (EPS). This method minimises the chance of examining sustainable results as opposed to short-term win projects.
Also, learn What is Trading on Equity here.
Limitations of Return on Equity
In addition, while the Return On Equity is a useful metric, it is not perfect. It has certain weaknesses that investors must accept before making a decision.
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Influence of debt: High ROE can be a result of excessive borrowing, which artificially inflates returns on the cost; however, it induces financial risk.
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Inconsistent earnings: Sometimes, due to one-time profits/losses, ROE is distorted for a specific year.
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Varying accounting practices: Different accounting practices for depreciation or valuation techniques to track assets can impact reported equity and thus change ROE.
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Sector comparisons: Drawing comparisons between ROE across unrelated sectors will produce misleading results as capital requirements vary.
Also, read What is Holding Period here.
Conclusion
There are no guarantees in the share market, so you must be very, very careful with any investment decisions you make. With a good understanding of precisely what Return on Equity is, you can try making investments that work in your favour. You must also note that no single metric can provide a perfect tool for examining fundamentals. It’s not a foolproof or guaranteed way to tell whether you should invest in a company or not. But one way to do that is by contrasting the five-year average ROEs within a specific industrial sector. This will highlight the companies with a competitive advantage and that have managed to deliver consistent profits to their shareholders.
Although ROE is a very good measure to gauge a company’s financial performance, it is not free from limitations. We suggest using Return On Equity formula judiciously to decide the merit of an investment option.
Lastly, think of ROE as a tool that will help you identify industry leaders. If the company has a high ROE, it could be a sign that the company has excellent potential to earn you profits. However, it is best to evaluate every aspect of the company before you make any investment decisions.