Return On Equity (What It Is And How It Works: Explained)

What is Return On Equity?

What does return on equity measure?

How does it work?

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Let me explain to you what is ROE and why it’s so important!

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What Is Return On Equity

Return on equity is a common financial measure where you divided a company’s net income by its shareholders’ equity.

In essence, when you calculate return on equity, your objective is to measure how well is a company generating a “return” or profits in relation to the shareholders’ equity.

If you think about it, the shareholders’ equity is the company’s total assets less its total liabilities.

As a result, if you are dividing a company’s total income by the company’s net assets, you are looking at the company’s profitability in relation to its net assets.

Benefits 

The main benefit of measuring ROE for investors is to see if they are going to get a good return on their investment.

Companies also can get a benefit in calculating their ROE as they can assess how well they are using their equity to generate profits.

Drawbacks

There are instances when calculating ROE may provide an investor with misleading results.

For example, if the company’s shareholder’s equity is reduced significantly as the company undertook significant debt, the ROE may appear to be significantly high and inflated.

Similarly, if a company is using capital to buy back shares, it can also inflate the ROE figures.

Return On Equity Definition

According to the Corporate Finance Institute, return on equity is defined as follows:

Return On Equity Formula

The return on equity formula is as follows:

The return on equity ratio formula will provide you with a percentage reflecting the company’s net income over the owner’s equity.

When the company’s net income or shareholder’s equity is netative, you get a negative return on equity.

This may not be a proper measure of a company’s overall performance.

Another ROE formula that you can use is:

Return On Equity Ratio

The return on equity ratio is a percentage measuring a company’s ability to generate a return in relation to its net assets.

For example, a company with a 20% return on equity is able to generate $0.20 for every dollar of shareholders’ equity on its books.

To determine what is a good ratio, you’ll need to compare the company’s figures to that of its competitors and peers.

It’s also important to measure a company’s ROE over time to see how this measure is evolving.

How To Calculate Return On Equity

To calculate return on equity, you will need to look at a company’s financial statements and extract the following information:

• Net income from its income statement 
• Shareholder’s equity from its balance sheet

With that, you’ll take the net income and divided it by the average shareholders’ equity to get return on equity.

The net income that you should consider is after the company makes all dividend payments to its preferred shareholders and interest payments but before any dividends are paid to common shareholders.

You can also calculate the company’s net income as follows: 

With regards to shareholder’s equity, you should consider the average shareholder’s equity by taking what was on the balance sheet at the beginning of the same period you are calculating net income and ending at the same time.

Return On Equity Interpretation

When you have a high return on equity, it means that your company is highly profitable in relation to its net assets or equity.

On the other hand, if you have a negative return on equity, it means that your company is actually losing money in relation to its assets and as a result is not profitable.

To get a better picture of how the company is using its assets to generate a return, you should compare the company to its peers in the same industry and other companies operating a similar business.

You can also compare a company’s historical ROE by considering the evolution of its profitability over time.

Sustainable Growth Rate

If you are looking to assess a company’s stock performance over time, you can calculate return on equity to measure the company’s sustainable growth rate.

For example, imagine that a company has an ROE of 20% and pays out 40% of its net income to its shareholders in the form of dividends (retaining 60% of its income).

Another company has an ROE of 15% but only pays 10% of its net income to its shareholders in the form of dividends (retaining 90% of its income).

The first company will have a sustainable growth rate of 12% (20% X 60%) whereas the second company has a sustainable growth rate of 13.5% (15% X 90%).

Dividend Growth Rate

If we add the company’s dividend growth rate to our assessment, we can better assess the company’s possible stock performance and risk.

Imagine that a company has a 20% ROE and a 12% sustainable growth rate based on a 40% payout ratio in dividends.

To calculate the company’s dividend growth rate, you’ll need to multiply the company’s ROE by its payout ratio (20% X 40%) equaling 8%.

This means that the company’s sustainable growth rate is above its dividend payout ratio and so the risk is possibly acceptable.

However, imagine that the same company has a payout ratio of 20% and a sustainable growth of 12%.

In this case, the investor should consider a possible risk that the company is losing capital over time by making a lot of dividend payments and may not be making the best possible use of its income.

ROE Calculation Limitations

Measure a company’s ROE can provide a good insight into a company’s financial health.

Just like many other financial ratios and measures, it’s important to assess a company’s ROE in relation to other ratios and factors to get an accurate picture of the company’s overall financial health.

Company Profitability

The primary reason why you may want to calculate the rate of return on equity is to assess the overall profitability of a company in relation to its net assets.

A company having a 20% ROE is generating more income than a company with a 5% ROE.

However, after doing your return on equity calculation, if you get a very high figure or a very low figure, it means that you’ll need to further assess the company’s risk.

For example, a company having a very low shareholders’ equity value (as it was not doing well for many years), may generate some profits this year and the ROE result may be very high (as you are dividend net income by a small denominator).

This can provide an investor with a misleading result if the investor does not further assess why the ROE is so high.

Company Indebtedness 

Another risk that a financial analyst or investor may not uncover with just the ROE calculation is a company taking on a lot of debt to inflate its return on equity.

For example, if a company goes out and borrows a lot of money and incurs a lot of debt, then it will have the obligation to reimburse lenders using its income.

Investors may not be that willing to invest in a company that is heavily indebted.

However, since the high level of debt will lead to a smaller shareholders’ equity value due to the shrinking net assets, the company’s ROE figure will get boosted giving the wrong impression to an investor that does not look at the company’s balance sheet further.

Net Income Losses

When a company has a negative income and a negative shareholders’ equity, you will get a positive ROE figure that will be quite misleading.

Typically, you should avoid calculating ROE when a company has either a net loss or a negative shareholders’ equity.

Intangible Assets

A limitation that you have when calculating return on equity is that the amount of intangible assets that are included in the company’s equity figures can inflate or deflate the figures.

Intangible assets are things like goodwill, patents, copyrights, and so on.

If one company includes the value of intangible assets in its equity and another does not, comparing their ROE ratios may not be very accurate.

Frequently Asked Questions

Let’s look at common questions that are asked in relation to “return on equity”.

What Is A Good Return On Equity

Determining what is a good return on equity will depend on how each financial analyst or investor evaluates a company’s profitability.

If you look at the return on equity ratio of the S&P 500 companies, it hovers around 14%.

As a result, if you assess a company’s ROE based on the average return on equity of S&P 500 companies, you’d consider that a 14% ROE is a good return on equity.

A good or bad ROE will depend on the company’s industry and how its peers are doing.

For example, you should not compare the average ROE of technology companies who tend to have high ROE to energy companies who tend to have lower ROE figures.

How To Find Return On Equity

To find ROE, what you need to do is to get the company’s average shareholders’ equity and divided it by its net income.

The net income is essentially the company’s total revenues minus expenses, taxes, interest and dividends to preferred shareholders (but not dividends to common shareholders).

Also, the shareholders’ equity is the company’s total assets less its total liabilities.

What Is The Return On Equity Equation

The return on equity equation is a formula used to evaluate how well a company is using its equity to generate profits.

The equation is pretty simple and consists of a company’s net income over average shareholders’ equity.

It’s important that you take the net income and shareholder equity figures for the same reference period to get an accurate measure.

What Is The Difference Between Return On Equity vs Return On Asset

Both return on equity (ROE) and return on asset (ROA) measure a company’s profitability in relation to the company’s assets.

Return on equity is a measure of a company’s profitability in relation to its net assets (total assets less total liabililites).

On the other hand, return on asset is the measure of a company’s profitability in relation to its total assets without considering the impact of its total liability.

What Is The Difference Between Return On Equity vs Return On Capital

Return on equity measures how well the company is utilizing investments in equity to generate a profit.

Return on capital takes the ROE calculation further by taking into account debt.

Return on capital is the company’s net income divided by the sum of shareholders’ equity and debt.

Return On Equity Meaning Takeaways 

So there you have it folks!

What does return on equity mean in simple terms?

How to calculate return on equity ratio?

Essentially, return on equity is a two-part ratio allowing you to bring figures from a company’s income statement and balance sheet together to assess its profitability.

ROE provides you the return that a company is generating in relation to its net assets.

In other words, you are measuring the company’s ability to generate profits from its equity investments. 

Return on equity is calculated by taking the company’s annual net income and dividing it by the average shareholders’ equity for the same reference period.

When you compare a company’s ROE to the industry average or its peers, you can then assess how well the company is performing in relation to similar businesses and its competitors.

Also, if you look at the company’s ROE figures over time, if you see sustainably growing ROE figures, you can conclude that the company is doing well and creating value.

The reason why measuring ROE is important is that shareholders and investors can assess if the company is generating value for them as the last stakeholders in the company in the company’s capital structure.

I hope I was able to explain to you the meaning of return on equity, how to calculate it, why it’s important, and its limitations.

Good luck!

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Understanding Return On Equity 

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