What is Return on Equity (ROE)?
Return on equity (ROE) shows the financial position of a corporation. In other words, return on equity measures a company’s profitability and reflects on how efficiently a company is handling shareholder dollars.
Below, we’ll show how to calculate return on equity and discuss what it says about a company.
How to Calculate Return on Equity
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Two figures, namely net income and shareholders’ equity, are required to calculate the ROE of a company. Let’s see what each represents.
Net income — It represents a company’s remaining revenue after deducting expenses. Revenue generated from activities such as the sale of assets is also part of the net income.
Shareholders’ equity — Shareholders’ equity is the amount of money belonging to the owners of a company, including stockholders since they own a portion of the company. It’s the money that remains after a company sells all its assets and deducts liabilities.
Return on equity (ROE) is given as a percentage. It’s obtained after dividing net income by the average shareholders’ equity.
For example, take technology firm X with an ROE of 18% and technology firm Y with an ROE of 14%. It implies that firm X is generating more profits as compared to firm Y. The owners of firm Y may want to find out the causes for this difference, and one of the reasons may be that the company is making bad investment choices.
What Does ROE Say About a Company?
ROE can help you as an investor gauge the financial health of a company whose shares you’d want to purchase. However, for accurate estimates, you should compare the ROEs of companies within the same industry since an ROE deemed bad in one sector could be good in another sector.
As an investor, you should focus on companies with an ROE equal to or slightly exceeding the average for that industry. For instance, if a company has been registering an ROE of 12% over the last ten years, and the average for its competitors was 8% within this period, this is a sign that the company has been efficient in generating profits. Investing in the company could therefore be a great idea.
Determining a Good ROE
Determining whether an ROE is good or bad depends on the company’s industry. But why? Corporations hold different volumes of assets and have varying levels of debts.
Some companies require more assets and debt to sustain their activities, while others need fewer assets and debt to continue operating. Comparing these two companies would be unfair and consequently misleading for an investor.
Is a Very High ROE Good?
The best ROE is one that’s just slightly above average. There may be an assumption that a very high ROE is preferable, probably twice as much as the average ROE of a given industry. However, this is not the case.
A super high ROE may be good in some cases, provided the net income is way more than equity. At times a very high ROE is risky since it means a company has small equity compared to its net income.
Causes of Extremely High ROE
A few factors could cause a company’s ROE to move to very high and undesirable levels.
Too Much Debt
If you can recall, equity is obtained by subtracting liabilities (debt) from assets. Therefore, a company with excess debt has lower equity, which increases ROE.
Negative Net Income
If net income and shareholders’ equity are negative, a company’s ROE can be very high. In most cases, negative shareholder equity is caused by fluctuating profits and too much debt.
Return on Equity vs. Return on Assets
Return on equity and return on assets (ROA) are vital for evaluating a company’s profitability, and ROA is simply a company’s net income divided by total assets. Just like ROE invested should compare ROAs that operate in the same sector.
The aspect of debt creates a difference between ROE and ROA. Assuming a company has no debt, the value of total assets will be similar to shareholders’ equity. And this would make ROE and ROA equal.
However, if a company has debt, its ROE would be more than its ROA. When a company takes on debt, cash flows into the company and, in return, increases its assets. In the end, you have a higher denominator while calculating ROA. So, ROE remains constant whereas the ROA falls.
Limitations of Return on Equity
Although ROE helps evaluate the performance of a company, it can sometimes give a wrong impression of the company’s financial health. Therefore, it should not be the only metric considered. For example, a company borrowing a lot has a high ROE because this would lower the denominator during calculations. But if the company misuses the money obtained from debt, it’s likely to perform poorly, and in this case, the high ROE is misleading.
Calculating ROE Using Excel
A company’s ROE is calculated by dividing its net income by shareholders’ equity. When using Excel, enter the net income in cell A3 and shareholders’ equity on the next cell to the right, which is B3. Input the formula as follows in cell C3: A3/B3*100. And that will give the percentage ROE.
The Bottom Line
Return on equity is a significant financial ratio, and any investor looking for good companies to invest in should study their ROEs. It points out how well a corporation utilizes its money to generate income.
A return on equity slightly above the industry’s average is the best, and ROE should not be used to compare companies in different sectors; instead, the companies should be in the same industry.
Lastly, investors need to observe other factors such as return on assets while sifting through potential stocks since the return on equity alone can sometimes be misleading.