Return on Equity (ROE)

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What is Return on Equity (ROE)?

Return on equity is a financial metric expressed as a percentage that helps measure how profitable a company is compared to the equity of its shareholders.

Key Takeaways

• ROE can help indicate how a company is managing its assets to generate profit.
• Shareholders’ equity and net income are the two factors used to determine ROE.
• ROE can be compared across companies within the same industry.
• Accounting standards and practices can impact the calculation of ROE.
• Don’t try to value a company based on ROE alone; instead, use the metric with other financial ratios when making an investment decision.

How ROE Works

The two factors used in the return on equity ratio are:

Net Income
A company’s profits after its expenses, taxes, and interest.
Shareholders' Equity
he value that would be returned to shareholders if all the company’s assets were sold and debts repaid.

After a company’s ROE is calculated, you will be left with the percentage of earnings generated from its equity. Then, you can compare the ROE to other companies within the same industry to determine whether it’s managing equity in a profitable way when juxtaposed to its competitors.

Calculating Return on Equity

The return on equity formula is as follows:

The DuPont Formula

You can break down ROE into several components to further understand a company’s financial performance using the DuPont Formula.

The DuPont Formula is as follows:

ROE= Net Profit Margin x Asset Turnover x Equity Multiplier

WHERE

• Asset Turnover = Revenue / Total Assets
• Equity Multiplier = Total Assets / Shareholders’ Equity

By using these additional factors, the DuPont Formula is a more detailed calculation for ROE. This can help you better understand specific variables and how they impact a company’s profitability and return on investment (ROI).

Return on Equity vs. Return on Invested Capital & Return on Assets

 Return on Equity (ROE) Return on Invested Capital (ROIC) Return on Assets (ROA) Definition Measures company profitability compared to shareholders’ equity Measures company profitability compared to invested capital Measures company profitability compared to total assets Useful for Comparing companies within the same industry Determining efficiency across industries Comparing industries with large assets Pros Easy to calculate and widely used by investors Helps determine capital efficiency, accounting for both debt and equity Helps measure the efficiency of asset usage Cons Does not account for debt Complex to calculate Can be misleading based on asset valuations

How to Use Return on Equity

As an investor, you may be wondering, “Why is ROE important?” For one, you can use ROE to compare the profitability of two competing companies, here’s how.

Imagine you calculate the ROE of a company as 30%. Meanwhile, the ROE for a competing company in the same industry is 35%. This means the competitor is 5% more efficient when it comes to generating profit from its shareholders’ equity and, all other things being equal, may be a more financially sound company.

Keep in mind that ROE is only one financial metric, and shouldn’t be used in isolation to make investment decisions.

ROE Example

Say a company has \$10 million in net income and shareholders’ equity of \$50 million. Its ROE could be calculated as follows:

ROE = [\$10 million / \$50 million] x 100

ROE = 20%

An ROE of 20% means that for every dollar of equity in the company, \$0.20 of profit is generated.

Using Return on Equity to Identify Risks

ROE can be a useful tool to help identify certain business risks, such as:

Debt
A high ROE can be a sign that a company is heavily leveraging its debt.
Inconsistent earnings
An ROE that fluctuates heavily over time can indicate a company that lacks consistent earnings.
Shrinking margins
If ROE is high but net profit is low, it could mean that the company has high revenues but is not efficiently translating them to profits.

ROE Pros and Cons

Pros
• Can help determine a company’s efficiency, profitability, and potential stock performance
• Useful for comparing companies within the same industry
• An easy formula to calculate
Cons
• Share repurchases can skew ROE higher and make a company look more favorable
• Can be artificially inflated from high levels of corporate debt
• Must be looked at with other financial metrics to make an informed investment decision

The Bottom Line

Based on the ROE definition, this financial metric can be an indicator of how efficient a company is at leveraging its equity to generate profits. You can get a company’s ROE from their financial statements or use a return on equity calculator to help with the formula.

Keep in mind that ROE can be skewed by high debt or share repurchases, and you, therefore, should use ROE in conjunction with other financial metrics before making investment decisions.

At the end of the day, ROE is one of many important financial metrics that can be helpful for investors.