What is Return on Equity?

Return on Equity, or ROE, is a profitability ratio that is typically used to evaluate the financial performance of a company. ROE shows the amount of net income produced from a dollar of shareholders’ equity, which may indicate how well a company is leveraging its investors’ money to generate income. This can help investors to determine if a company is performing well and if investing in the company would be profitable.

Calculation of return on equity

To calculate ROE, net income is divided by the shareholders’ equity. Net income refers to the revenue of a company less expenses such as the cost of goods sold, operating expenses, interest, taxes. Shareholders’ equity is calculated by subtracting a company’s total liabilities from its total assets. Both net income and shareholders’ equity are reflected on a company’s income statement and balance sheet respectively. The net income and shareholders’ equity used for calculation should be over the same period of time. ROE is usually expressed as a percentage.

Example of return on equity calculation

A company has a net income of $100,000, total liabilities of $600,000 and total assets of $1,000,000. The company’s shareholders’ equity would be $400,000 by subtracting $600,000 of total liabilities from its total assets of $1,000,000. By dividing the net income of $100,000 by the shareholders’ equity of $400,000, the ROE of the company would be 25%. This means that for each dollar of shareholders’ equity, the company is able to use that dollar to generate 25 cents in net income.

Net income = $100,000
Total liabilities = $600,000
Total assets = $1,000,000
Shareholders' equity = $1,000,000 - $600,000 = $400,000
Return on equity = $100,000 / $400,000 = 25%

Is a high or low return on equity considered good?

A higher ROE is deemed to be better as it suggests that the company is able to efficiently use its equity financing to generate income. A low ROE may indicate that the company is inefficient in its use of investors’ capital by investing in unproductive assets or the company may be mismanaged.

However, there are no clear guidelines as to what constitutes a “high” or “low” ROE as it varies across different industries. A company’s ROE should be compared to the ROE of similar companies within the same industry, with an average ROE of the industry as a benchmark.

A company with an ROE that is higher than its competitors in the same industry usually suggests that the company has a competitive advantage that allows it to generate higher net income. For example, the average ROE for companies in the banking industry is 8.22% while the average ROE for companies in the pharmaceutical industry is 11.98%. A banking firm with a 9.5% ROE is well above its industry average, suggesting that the banking firm is profitable and performing better than its competitors. It would be erroneous to compare the banking firm to companies in the pharmaceutical industry, with a much higher average ROE, and deem it as lacklustre.

Limitations of return on equity

Although ROE may help investors to determine which companies are profitable to invest in, investors should not solely rely on ROE to make their investing decisions.

Firstly, ROE can be manipulated to reflect that a company has a higher ROE without actually being more profitable. Manipulations can come in the form of write-downs and share buybacks, with the aim of decreasing shareholders’ equity. When a company has a significant write-down, it decreases the shareholders’ equity due to impairment loss of the asset. When a company buys back its own shares, it reduces the amount of outstanding shares, decreasing the shareholders’ equity.

Secondly, intangible assets, such as trademarks, goodwill and patents, lower shareholders’ equity as a fair value cannot be placed on these intangible assets and their monetary value is typically excluded from the shareholders’ equity. Therefore, shareholders’ equity may typically be undervalued.

Thirdly, ROE does not give a clear picture on how much debt is undertaken by a company. A company may be more reliant on debt financing than equity financing and may be taking on more debt than necessary. This decreases the shareholders’ equity, allowing a company to present a higher ROE. Additionally, a company that is overleveraged may be a riskier investment due to a higher risk of default.

These methods can inflate a company’s ROE and may present a misleading perspective on a company’s profitability. ROE should be used in conjunction with other profitability ratios, such as return on assets, and gearing ratios, such as debt-to-equity, to project a more holistic view of a company’s financial health.

Return on invested capital (ROIC) is a further calculation on ROE that determines how well a company leverages all its available capital to make money. The ROIC is another potential profitability ratio that could be used in conjunction with ROE to determine a company’s financial health.

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Disclaimer: The information and/or documents contained in this article does not constitute financial advice and is meant for educational purposes. Please consult your financial advisor, accountant, and/or attorney before proceeding with any financial/real estate investments.