What is Return on Equity (ROE)?

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.

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 don’t rely solely on ROE for investment decisions. The reason is, it can be artificially influenced by the management and hence not the most reliable of parameters. For instance, when debt financing is used to reduce share capital, there will be an increase in ROE even if 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%.

After careful evaluation, an investor would conclude that NetCo’s management is faring better than others at using the company’s assets to create profits.

How do you calculate ROE?

ROE is an important metric for investors to evaluate profitable investment opportunities. Companies with higher ROE attracts 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 ROE formula, which gives a workable idea of 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 the value of net income from the company’s income statement, denoting earning before a company pays out a dividend to its 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. 

Why studying ROE formula is significant?

Study of ROE formula reveals the merit of investing in a company. But it has several other applications. Here is why studying ROE is so important.

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.

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.

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. 

ROE Formula to determine company’s growth

Calculating return on equity can give a rough idea about company’s growth over time. Comparing past ROE with the current value, one can draw a comparison between the firm’s past performance regarding growth in stocks and dividend.

Identifying financial problem

Investors and management use ROE formula to determine financial discrepancies.  There can be instances when the ROE formula helps highlighting inconsistencies in reporting ROE. For instance, if a company is struggling with losses, it will have low ROE. If now, it makes a profit for one year, the return on equity value will turn out to be very high, indicating inconsistency. 

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

  1. 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.
  2. Companies with high ROE are good at retaining earnings. Retained earnings is a source of capital for any business. When a company maintains its earnings and ploughs it back as working capital, the need for debt goes away meaning the company is free from any 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.
  3. 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 are resulting 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, as the return for such companies is zero. 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.

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 is Return on Equity, 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 fool-proof 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 who have managed to deliver consistent profits to their shareholders.

Although ROE is a very good measure to gauge company’s financial performance, it is not free from limitations. We suggest using ROE formula judicially 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.