Return on Equity (ROE)

Return on Equity (ROE)

What Is Return on Equity (ROE)?

Return on equity (ROE) is a profitability ratio that measures the return that shareholders earn on their investment in a company.

ROE combines a company’s net income with its balance sheet to give investors an idea of how well management is using the company’s assets to generate profit.

Generally speaking, a higher ROE is better. It indicates that a company is more profitable and can generate more return on the money shareholders have invested.

However, there are some limitations to ROE that investors should be aware of. We’ll discuss those later in this article.

For now, let’s take a closer look at how return on equity is calculated and what it means.

 

How to Calculate Return on Equity (ROE)

As we mentioned, return on equity is calculated by dividing a company’s net income by its average shareholder equity.

There are a few different ways to calculate shareholder equity, but the most common is simply total assets minus total liabilities.

Shareholders’ equity = Total assets − Total liabilities

ROE example

For example, let’s say Company XYZ has assets of $200 million and liabilities of $150 million. This gives it shareholder equity of $50 million.

Now let’s say that over the course of one year, Company XYZ generates a net income of $10 million. This gives it an ROE of 20 percent (($10 million ÷ $50 million) × 100).

It’s important to note that ROE can be affected by a number of different factors, including a company’s leverage (i.e. its debt-to-equity ratio).

For example, let’s say that Company XYZ has the same assets and liabilities as before, but this time it also has an extra $25 million in debt. This gives it total equity of $25 million (($200 million − $150 million) − $25 million).

Now, let’s say that over the course of one year Company XYZ generates a net income of $10 million. This gives it an ROE of 40 percent (($10 million ÷ $25 million) × 100).

As you can see, adding debt has effectively doubled the company’s ROE, even though its net income has remained the same.

In fact, its total capital increased even though its net income remained the same.

This is why it’s important to consider a company’s leverage when looking at its ROE.

A company with a lot of debt may have a high ROE, but that doesn’t necessarily mean it’s a good investment.

 

Interpretation of Return on Equity

Investors use ROE to evaluate a company’s performance and compare it to other companies in its industry.

A high ROE indicates that a company is doing a good job of generating profit from its shareholders’ investment.

ROE can also be used to evaluate a company’s management.

A company with a consistently high ROE is likely being managed well, while a company with a declining ROE may be going through a rough patch.

 

What Is a Good or Bad Return on Equity?

Whether ROE is high or low will depend on a company’s peer group.

An asset-intensive company, such as auto manufacturing or utilities, may have a lower ROE than an “asset-lite” tech company.

That’s because asset-intensive companies require more capital to generate profit, so their ROE will be lower by nature.

Within an industry, a company with an ROE that’s significantly higher than its peers may be doing something right and may be worth further investigation.

Conversely, a company with an ROE that’s much lower than its peers could be underperforming and may be a riskier investment.

 

Factors That Affect Return on Equity

There are several factors that can affect a company’s return on equity.

Some of these factors are within management’s control, while others are out of their hands.

Here are some of the most common factors that can affect ROE:

Profitability

Obviously, a company’s return on equity will be lower if it’s not generating profit.

That’s why profitability is one of the most important drivers of ROE.

Investors should always keep an eye on a company’s profitability metrics, such as net income and gross margin, to get an idea of how well it’s doing.

Asset Utilization

Another key driver of ROE is asset utilization.

This refers to how well a company is using its assets, such as cash, inventory, and property, to generate profit.

A company with high asset turnover (sales divided by assets) will typically have a higher ROE than a company with low asset turnover.

That’s because if a company is using its assets efficiently, it will generate more sales from each dollar of assets and will have a higher ROE.

Leverage

Companies that use debt to finance their operations can increase their ROE by using leverage.

However, too much leverage can lead to financial problems if the company isn’t able to generate enough income to service its debt.

That’s why it’s important for investors to keep an eye on a company’s leverage ratios, such as its debt-to-equity ratio, to make sure it isn’t carrying too much debt.

Taxes

Taxes can also have a significant impact on ROE.

A company with a high tax rate will have a lower ROE than a company with a low tax rate.

That’s because taxes reduce net income, which in turn reduces ROE. (That’s also why tax cuts tend to increase stock prices and why tax hikes tend to decrease them.)

Investors should always be aware of a company’s effective tax rate so they can understand how much of its profit is being eroded by taxes.

Business model

Some business models are simply more profitable than others.

For example, a company that owns and operates its own factories will typically have a lower ROE than a company that outsources production to lower-cost areas.

That’s because owning and operating factories requires a lot of capital, which leads to a lower return on equity.

Sustainability

Finally, it’s important to consider whether a company’s return on equity is sustainable over the long term.

A company may be able to boost its ROE in the short term by using aggressive accounting practices or taking on too much debt.

However, these strategies are not sustainable and can lead to financial problems down the road.

Investors should always analyze a company’s return on equity over time to get an idea of whether it’s sustainable.

 

Return on Equity and Stock Performance

Return on equity is not a perfect metric, it can still be a useful tool for analyzing stocks.

In general, companies with high ROE tend to outperform the market, while companies with low ROE tend to underperform the market.

That’s because ROE is a good measure of profitability and investors are always looking for profitable companies to invest in.

Of course, there are exceptions to this rule. For example, a company with a high ROE but low profit margins may be overvalued by the market.

Similarly, a company with a low ROE but high profit margins may be undervalued by the market.

So, while ROE is a good starting point for stock analysis, it’s not the only metric that investors should look at.

The P/E ratio is another important metric to consider when analyzing stocks.

Companies in the S&P 500 generally have a return on equity in the low-20%s.

 

Using ROE to Identify Issues

Return on equity can also be distorted by thing like one-time items that increases or decreases net income, or the existence of a small or large equity account.

For example, a company could have low earnings but a low equity account that gives them a large ROE.

But in that case, you might suspect that the high ROE is misleading.

In fact, the low equity account could also indicate that there may be insufficient equity funding in the business.

This is just one example of how return on equity can be distorted and why it’s important to look at other financial metrics in addition to ROE.

The takeaway here is that return on equity can be a useful metric for analyzing stocks, but it’s not perfect.

Investors should always consider other factors, such as other valuation ratios, before making any investment decisions and not to tunnel in on just one metric or a handful of metrics.

 

How ROE Can Be Distorted

There are many ways that ROE can be misleading.

Inconsistent earnings

If earnings jump around a lot, it’s hard to get a good read on a company’s true ROE.

That’s because ROE is calculated using net income, which can be volatile from one year to the next.

A company with consistently high earnings will typically have a higher ROE than a company with volatile earnings.

One-time items

One-time items can also distort ROE.

For example, if a company sells off a division at a profit, that will increase its net income and ROE for that year.

But that doesn’t necessarily mean the company is more profitable or has a better business model.

It’s important to adjust for one-time items when analyzing return on equity. Otherwise, you might misinterpret a company’s profitability.

Aggressive accounting

Another way that return on equity can be distorted is through aggressive accounting practices.

For example, a company might choose to capitalize certain expenses instead of booking them as expenses.

This will increase the company’s net income and ROE, but it’s not a true reflection of profitability.

Investors should be aware of these accounting tricks and adjust for them when analyzing return on equity.

Related: The Complete Guide to Cash Flow Analysis

Negative earnings

If a company is still growing a lot, then its ROE is likely not a good indicator of its viability.

A company with negative earnings but strong revenue growth may still be a good investment, despite its low ROE.

High debt relative to equity

If a company has high debt relative to equity, it may sometimes have a high ROE just because the equity account is so small.

Equity is equal to assets minus debt.

So high debt will shrink the shareholders’ equity figure.

In that case, using return on capital (ROC) or return on invested capital (ROIC) may be the better metric.

A company producing a high ROE off a small equity account may actually suggest risk due to insufficient equity capitalization.

In that case, despite seeming like a high-quality investment via the ROE metric, it may actually be the opposite.

Sometimes a metric can take on a large value simply because of a low denominator.

 

Limitations of ROE

While return on equity is a useful metric, it does have some limitations.

First, ROE doesn’t give you any information about a company’s valuation.

In other words, just because a company has a high ROE doesn’t mean its stock is a good buy.

You need to look at other factors, such as the price-to-earnings ratio, before making any investment decisions.

Second, return on equity can be distorted by things like one-time items or aggressive accounting practices.

So it’s important to adjust for those factors when analyzing ROE. Otherwise, you might misinterpret a company’s profitability.

And third, ROE only tells you about a company’s past performance.

It doesn’t necessarily predict how the company will do in the future.

So while return on equity can be a useful metric, it’s not perfect.

 

Return on Equity – FAQs

What Does Return on Equity Mean?

Return on equity ratio measures how well a company is using its assets to generate profit.

A higher ROE indicates that a company is more profitable and can generate more return on the money shareholders have invested.

However, return on equity is just one profitability ratio and shouldn’t be viewed on their own. Investors should always look at a variety of ratios and metrics in order to get a comprehensive view of a company’s profitability.

How Do You Calculate Return on Equity?

The return on equity ratio is calculated using the following formula:

ROE = net income / shareholders’ equity

To calculate ROE, you need two pieces of information: net income and shareholders’ equity. Both of these can be found in a company’s financial statements, with net income on the income statement and shareholders’ equity on the balance sheet.

What Is a Good ROE?

There is no one-size-fits-all answer to this question, as it depends on the industry and other factors.

However, in general, a higher return on equity is better than a lower return on equity.

Investors should always compare return on equity to other companies in the same industry to get a better sense of what is considered a “good” ROE.

What Does ROE Tell You?

Return on equity can give you an idea of how well a company is using its asset base to generate earnings.

A high return on equity indicates that a company is profitable and efficient. A low return on equity may suggest that the company is not using its assets effectively.

What Are Some Limitations of Return on Equity?

There are several limitations to return on equity that investors should be aware of.

First, return on equity can be distorted by a variety of accounting practices. For example, a company might choose to capitalize certain expenses instead of booking them as expenses. This would increase the company’s ROE, but it’s not a true reflection of profitability.

Second, return on equity may not be a good indicator of a company’s viability if it is still growing a lot. A company with negative earnings but strong revenue growth may still be a quality investment, even if it has a low ROE.

Third, return on equity can sometimes take on a large value simply because of a low denominator. If a company has high debt relative to equity, it may sometimes have a high ROE even if it’s not particularly profitable or because its equity base is low.

For all these reasons, return on equity should be viewed as just one metric among many when assessing a company’s financial health and its quality as an investment.

 

Summary – Return on Equity

Return on equity is a key metric for evaluating a company’s profitability and financial health.

It measures how much profit a company generates from each dollar of equity and can be affected by various factors, such as profitability, asset utilization, leverage, taxes, and its business model.

In general, companies with high ROE tend to outperform the market, but there are exceptions to this rule.

So, while ROE is a useful metric for stock analysis, it’s not the only metric that investors should consider.

 

 

by