Be it a firm or investors looking to invest in profitable companies, it is important to measure the company’s performance and how it generates wealth. Return On Equity (ROE) is an effective tool that can help investors and companies measure the performance of their companies.
However, there are some important guidelines that companies and investors should know before calculating and determining the ROE of the company. This article will tell you in detail what ROE is and how it can help with a company’s growth.
What Is Return on Equity (ROE)?
Return On Equity or ROE is the measurement of a corporation’s performance over some time. It can help business owners measure their company’s performance and provide insights on managing equities and investments to produce returns.
ROE is important for any business because it is the first aspect that prospective investors would consider when deciding to invest in a business. So, the higher the ROE of a business, the more efficient it would be at generating income and growth from its equity financing.
Check out our article on Comparing Equity and Debt Financing.
How to calculate Return on Equity?
The ROE is expressed in terms of percentage and can be assessed for any business that has both net income and equity in positive numbers. The ROE of a company can be determined by assessing the net income of the brand and dividing it by the shareholder’s equity.
Return On Equity (ROE) = Net Income (annual) / Equity of the shareholders
Net Income: The net income of a corporation is the profits it gains after deducting costs such as taxes, expenses, interests, depreciation, and more.
Shareholder’s equity: The shareholder’s equity is the remaining claim/profits that the shareholders have after all the debts of the corporation for a given period have been cleared.
How to calculate ROE in Excel?
The ROE can be calculated by dividing the net income by the shareholder’s equity. Given below is how Microsoft Excel can be used to calculate ROE.
- Let’s consider column A to input Net Income, column B to input the shareholder’s equity, and column C to calculate the percentage of ROE.
- To calculate ROE enter the relevant details of the net income and Shareholder’s equity in the relevant cells A2 and B2.
- In cell C2, enter the formula to calculate ROE, i.e., A2/B2. The resultant figure is the ROE of a business.
The resultant ROE can sometimes be negative, but that doesn’t mean the business has a negative cash flow. A negative ROE is not bad but can be investigated and improvised.
How does ROE work?
ROE (Return On Equity) is a useful metric when one wants to evaluate the returns of investment of a company. Investors can use ROE to compare and assess a company’s ROE against the industry average to get a general idea on its performance compared to its competitors.
It is better to target companies that have an ROE that is equal to or just above the industry average for that particular sector. The ROE of a business will vary depending on the industry or sector in which it operates.
A high ROE means that a company uses its shareholder’s equity efficiently to generate income. A low ROE means that income generated by the company is lower than the shareholder’s equity.
Analysing Return On Equity Ratios (ROEs)
Given below is an overview of the ROE ratio interpretation.
- The ROE ratio helps measure how efficiently a company uses its shareholders’ investment to generate more revenue.
- The ROE ratio is a projection of investors’ investment in the company.
- Mostly, a high ROE shows that a company is efficiently utilizing the funds generated through the investment of the shareholders.
Why is ROE Important?
For investors who are looking for a good company to invest in, the first thing they would look into is the profits that can be generated through the investment. Investors can gauge a company’s ability to make money by looking at its ROE Ratio.
Return On Equity can also be useful for comparing different companies’ stocks in the same industry. Investors can use this to choose the best company to invest in.
Limitations of the ROE Ratio Measure
Some of the limitations of Return On Equity are given below.
- When it comes to new companies the initial stages require a high capital investment, leading to a lower ROE.
- Various accounting restrictions, like depreciation rate, increasing project life, etc., can influence the ROE ratio.
- When evaluating a company’s competence and performance, a negative return on equity ratio that results from a negative shareholder’s equity or net loss will not be useful.
- The economic worth of a firm, which depends on several economic elements like depreciation, project lifespan, investment growth rate, capitalization policy, etc., is often overstated by the ROE.
Return on Equity vs Return on Assets
Return On Equity (ROE) and Return On Assets (ROA) are two important measures that most companies use to evaluate how efficiently their capital and profits are managed. The main difference between ROE and ROA is that, while ROE does not consider the leverage/debt while calculating, ROA takes into account the financial leverage/debt of a company.
If there is no debt, the shareholder’s equity and the business’s total assets will be equal, making its ROE and ROA almost the same. But if the business has a debt or gets financial leverage, then its ROE will be higher than its ROA.
Investors usually consider both metrics to evaluate the efficiency of a company’s management. Both ROE and ROA may differ depending on the company, so it’s important to consider them while looking into other financial performance metrics.
Benefits of ROE
Estimating the growth rate
Regardless of the few setbacks of ROE, it is still considered an effective way to assess the performance and growth rate of a company’s stock values.
Gauging the sustainability of growth
ROE ratio further helps in assessing the sustainability of a company in terms of growth. Through this, investors can identify stocks more prone to financial instabilities and market risks.
Identifying problems with the ROE ratio
ROE ratio can be used to scrutinize certain aspects like excessive debts, negative income, and erratic returns. If a company’s net income is higher than ROE, it indicates the company’s strong performance. If the net income is less than ROE, it means the company is at risk.
How to Interpret ROE?
The return on equity (ROE) metric provides useful insights into how efficiently existing and new equity invested in the company is utilized.
- High ROE Ratio: The higher the ROE, the more the company is earning in net profits with those proceeds provided by equity investors.
- Low ROE Ratio: The lower the ROE, the less the company earns in net profits with the proceeds from equity investors.
Over time, if the ROE of a company is steadily increasing, that is likely a positive signal that management is creating more positive value for shareholders.
Note the net income value should be taken before any issuance of dividends to common shareholders, as those payments impact the return to common equity shareholders.
Meanwhile, the preferred dividends, which receive debt-like treatments, should be deducted from net income.
Is there an ideal return on equity?
A range of ROE cannot be declared as a good return on equity because the ROE ratio differs from sector to sector. Some sectors prefer an ROE of over 25%, while others may consider a value above 15% to be remarkable. Lower ROE does not, however, inevitably mean imminent doom for a company. The ROE may occasionally decrease in a specific year for a variety of reasons.
For example, a business may have recently acquired some essential machinery after getting a quantity of new investment. In such a scenario, the return on equity for the aforementioned business would temporarily drop. Therefore, to assess the genuine condition and performance of the firm, investors would need to ascertain the long-term ROE.
What makes ROE an imperfect scale?
Each time a company’s shareholder equity pool declines, the ROE of the company increases. Thus, a decline in the investment in the company can positively affect the ROE of the company.
It is widely believed by many experts that ROE is a faulty scale for measuring a company’s success or failure. Below are the reasons why.
Return On Equity is one of the most crucial financial statistics for stock investors who are looking for firms with a compelling value proposition. It’s an easy-to-understand and practical indicator of how effectively a company can return on the capital invested in it.
Although a high and consistent ROE is typically preferable, the industry should be taken into account when evaluating the absolute value. It is also a good thing if ROE rises with time.
Is having a 20% ROE good?
Having a 20% ROE is a good sign as it indicates that the company’s net income divided by the shareholder’s equity is 20%. It shows that the company is managed well and the shareholders can get excellent returns on their investments.
Why can the ROE of a company be misleading?
The ROE ratio of a company can be misleading at times. For example, a company can artificially boost its Return On Equity by relying more on debts than its equity. This can negatively affect their financial solvency.
Is ROE effective in measuring the performance of a firm?
Yes, ROE is an effective way to measure the performance of a firm. The greater the ROE, the more effectively the firm can manage and generate income. ROE is often used to evaluate and compare the performance of competitor firms by investors to choose which firm to invest in.