When investing in the stock market, an investor should learn about the different financial ratios used for the fundamental analysis of companies. Return on equity (ROE) is an essential parameter that helps potential investors analyse a company’s profitability. It indicates how well a company has utilised its shareholders’ money. One can calculate a company’s ROE by dividing the net income of the company by total shareholder equity and is denoted by percentage.
The following sections in this blog will cover more essential details about return on equity.
What is return on equity?
- Return on equity (ROE) is an important metric for understanding a company’s financial health and performance.
- It is a company’s net income divided by equity financing.
- This measure helps in understanding how efficiently shareholder equity has been utilised to generate profits.
- ROE gives insights into profitability and the efficiency of profit generation.
- Standard ROE values differ widely across industries.
- Typically, a higher-than-average ROE indicates a company’s ability to efficiently convert equity capital into profits.
Why is ROE so important?
The meaning of return on equity is described as a financial ratio that calculates the net profits earned by a company as a percentage of the shareholders’ equity.
So, what does it mean when a company has a low ROE? It indicates that the company has not been able to make good use of the money invested by its shareholders. In other words, a low ROE implies that the company is unlikely to offer high returns to its investors.
While every stock market investor should know how to check, compare and analyse the ROEs of different companies, it should not be the only factor guiding one’s investment decisions. The management of a company can manually alter its ROE and it would prevent investors from making accurate analyses of a company’s financial condition.
Difference between rate of return and return on equity
The rate of return in concept sounds similar to the return on equity. However, there are significant differences between the two measures. These differences are highlighted in the table below:
Return on equity | Rate of return |
This is a measure of how efficiently investor money is being utilised by a company | This is a measure of an investor’s profits from one of their investments in a given company over a set period |
This metric is largely used in the stock market | This metric can be used to calculate returns on all forms of investments |
How to calculate ROE?
The return on equity formula is as follows:
Return on equity = Net income/ equity of the shareholders
In this formula, ‘equity of shareholders’ stands for the average equity available for the business’s shareholders. It is defined as a company’s net worth that would be returned to its shareholders after the company liquidates itself and pays off its debt.
The company’s net income is simply available in the company's income statement. It is the earnings of a company before the latter has paid dividends to shareholders. Some financial analysts prefer checking the net income of the previous twelve months while measuring ROE.
There are some important factors that investors must remember regarding the ROE formula. One can estimate a company’s net income by subtracting its cost of goods sold (COGS), selling, general and administrative expenses (SG&A), amortisation, depreciation, taxes and interests from its sales revenue.
Investors should also note that net income is also called net earnings or net profit.
What is an ideal Return on Equity (ROE)?
It is difficult to establish a standard range for return on equity (ROE) that is universally applicable to all investors and industries due to the considerable variation in ROE across sectors. In some industries, an ROE above 25% is deemed excellent, while in others, a figure exceeding 15% might be considered outstanding. Yet even a lower ROE is not always a red flag. There can be instances where a company’s ROE may temporarily decline due to various reasons, and this drop does not necessarily signal trouble.
For instance, a company may choose to invest in upgrading its machinery or expanding its physical infrastructure. During this period of reinvestment, the ROE could drop, but this reduction is only temporary and may indicate future growth and increased returns over the long term. Therefore, a snapshot of ROE in any single period may not fully reflect a company’s true financial health.
There are also scenarios where a high ROE could be a cause for concern:
- Declining equity investment: If a company’s ROE increases due to a reduction in shareholders’ equity rather than improved profitability, it is not a positive indicator. For example, a company could maintain the same level of net income while its equity investment drops, resulting in a higher ROE. However, this may actually reflect a weakening financial position rather than increased profitability.
- Increased debt: Another situation that could inflate ROE is when a company takes on significant debt. While debt may boost ROE in the short term, it increases the company’s financial risk. Therefore, relying solely on ROE as a measure of a company's profitability can be misleading.
Furthermore, certain types of companies, especially new firms or those in capital-intensive industries, might exhibit a low or even negative ROE in their early stages. This is not always a sign of poor management but rather a reflection of the nature of the business during its growth phase.
Given these limitations, seasoned investors understand that ROE should not be the only metric used to assess a company’s potential. It is essential to consider other financial indicators and metrics alongside ROE to gain a comprehensive understanding of a company's overall performance and future prospects.
How to interpret ROE?
The interpretation of ROE can be tricky for young investors. Usually, a company’s steadily increasing ROE is a good sign, which indicates that more and more shareholders are investing (and placing their trust) in the business. But, for a company to increase its profits faster than its ROE, it needs to borrow money. Even this strategy only works briefly because taking on more debt eventually reduces the company's net income. Owing to this, fund managers study a company's ROE to gauge its potential growth, as the ROE limits how much the company can grow and expand.
Also, as mentioned in the previous section, ROE is best utilised when considered along with other metrics of financial and technical analysis.
Why studying the ROE formula is significant?
Discussed below is the importance of the ROE formula:
- ROE depicts a company’s financial soundness, including the strength of its organisational framework.
- Investors can use this formula to analyse the financial growth of a company. It indicates whether a company has grown steadily over the years or not.
- While one cannot use ROE to determine the financial performance of companies in different sectors, one can still use it to compare the performance of companies in the same segment.
- Management professionals and investors use the return on equity formula to analyse whether there are financial discrepancies in a company’s balance sheet or not.
Limitations Of ROE
After learning the meaning and uses of ROE, let us also look at some of its drawbacks to understand why it is used in a limited capacity. Here are some of the drawbacks of utilising ROE:
- A company's ROE increases when the total amount of shareholders' equity decreases. So, if fewer people invest in the company, the ROE can look better.
- A high ROE does not always mean a company is well-managed. Instead, it could mean the company has significant debt. High debt reduces a company's equity, increasing the ROE. So, even if a company is struggling with debt, a high ROE might hide this problem from potential investors who look at the return on equity to make decisions.
- The ROE calculation only includes tangible assets possessed by a company. This measure excludes patents, brand names, trademarks, and other intangible assets from the calculation, giving an incomplete outlook of the company's performance and asset management.
- The return on equity can also be easily manipulated by a company’s executives to twist the numbers to their benefit. They often do this because a higher ROE can lead to bigger bonuses and higher pay for themselves. While boosting the ROE might make the executives look good and benefit them personally, it can harm the company in the long run.
What do companies with high ROE indicate?
Here’s what a high ROE indicates for companies:
- Companies that have a high return on equity are well-equipped to make optimum use of shareholders’ money. It indicates to people that investing in the company would be a good option as it will continue to generate profits.
- Companies with a high ROE have expertise in retaining earnings and retained earnings are a good source of capital. Investors should check a company’s annual retained earnings and ROE for a year. If they witness that a company has generated profits and has a good ROE, it can successfully retain earnings.
- With a high ROE, a company has a significant advantage over its peers because it can better protect its long-term profits and enjoy a substantial market share.
How to use ROE in three ways?
- Investors can use ROE to estimate the sustainable growth rate and dividend yields of a company.
- As mentioned, a high ROE tells investors that a company is financially strong.
- People can also use the DuPont formula to analyse the factors resulting in high/ low ROE. The formula is as follows:
ROE (Return on equity) = (Net income/revenue from sales) x (sales revenue/total assets) x (total assets/shareholders’ equity)
Can the ROE of a company be in the negative values?
Yes, a company can have a negative ROE. Such companies yield zero returns. A negative ROE can be a result of the company having negative shareholder equity because its liabilities currently exceed its assets at a particular time.
Investors should remember that it isn’t a good idea to disregard a company with a negative ROE. While a return on equity is a suitable financial parameter to understand a company’s financial performance, investors should not be over-reliant on it.
It is an effective tool to identify industry/ market leaders, but one should also consider other aspects such as its PE ratio, debt-to-equity ratio, operating profit margin, etc.
Conclusion
Return on equity (ROE) is an important metric for assessing a company’s profitability and financial health. It shows how well a company uses shareholders' money to generate profits. However, investors should not rely solely on the return on equity’s ratio. It is important to consider other financial ratios and metrics to get a complete picture of a company's performance. While ROE can indicate efficiency, it can also be misleading. Therefore, a balanced approach using multiple indicators is recommended for making informed investment decisions.
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