Key Takeaways:
- ROE indicates the company’s capability to turn equity capital to net profit.
- ROE provides a metric to evaluate investment returns.
- Higher ROE indicates effective utilization of the equity to generate profits by the company.
What is Return on Equity (ROE)?
Return on equity measures how effectively a company uses its equity. In other words, ROE measures profits made for each dollar from shareholder’s equity. It indicates the company’s capability to turn equity capital to net profit.
How to Calculate ROE?
ROE is calculated by using the following formula:
ROE = Net income / Shareholder’s Equity
Net income is listed in the income statement of the company and is profit, less expenses and taxes. It is the sum of the financial activity of the company for the given fiscal year. Shareholder’s equity is calculated by adding equity at the beginning of the period and is found in the balance sheet. It is preferable for the analysts to calculate average return on equity over a period of time.
ROE is often analyzed in comparison to the industry average. If company A’s ROE is averaging at 15% over the past 3 years while the industry has been averaging at 11%, it is presumable that company A has a great management team due to their effective utilization of the equity to generate profits.
Understanding Return on Equity (ROE)
ROE provides a metric to evaluate investment returns. By comparing to the industry average, a company’s competitive advantage may be realised. A sustainable and increasing ROE of a company may mean that the company is effectively generating shareholder value by being smart about reinvesting their earnings to increase their profitability and productivity. In contrast to this, declining ROE may indicate poor decisions by the management regarding reinvestment of capital in unproductive assets.
It is important to note that an extremely high ROE is a good thing only when the net income is extremely large relative to the equity because that will indicate how strong the company’s performance is. However, usually an extremely high ROE is due to smaller equity relative to net income, which then indicates risk.
