Return on Equity (ROE) is the financial measure when you divide net income by shareholders’ equity. It can only be determined if the net income and equity are both positive numbers. The Return on Equity is an accurate measure of a company’s profitability as it measures how the company’s profits affect stockholders’ equities.
ROE is commonly expressed as a percentage. Other ways to express Return on Equity are Return on Assets minus Liabilities.
How Does Return on Equity Work?
ROE measures and compares the financial performance of different firms in the same industry. In the following sessions, we’ll be paying more specific attention to how Return on Equity works.
What Does Return on Equity Tell Investors?
ROE lets investors know which companies to put their money on and which ones to stay clear of. This is because it shows which companies are ahead and those that are behind within the industry. Investors use these profitability indices to analyze what companies are profitable and by how much.
What Is a Good Return on Equity?
After calculating ROE, it can either be positive or negative. So how do you decide whether to invest in a company or not? What is a good Return on Equity?
A high Return on Equity implies that the company’s management efficiently uses the finances they have to grow their business. This means that the management is investing the shareholder funds into gainful assets which will yield profit.
While a high Return on Equity may suggest an efficient use of resources, it may also be a warning sign. Sometimes, a high ROE reveals that the company is in a lot of debt. As a result, you should exercise proper caution before interpreting high ROE to mean productivity.
Where the high Return on Equity shows a negative situation for a company, it may be as a result of the following:
- Huge debts
- High ratio of equity to debt
- Uneven profits
To fully understand and interpret a high Return on Equity, pay attention to the particular industry the company is in. The average ROE in the industry determines whether or not the High ROE is negative or positive. To get the best results, we advise comparing two or more firms in the same industry. When you do this, it is easier to put the data in context and figure out their differences.
Examples of High ROE
Say Company A hits an ROE of 15% in an industry where other companies average an ROE of 11%, it is positive. This shows that Company A’s management team is efficient in their use of company equity to maximize profit. This conclusion is solid only because the debt usage is the same all across the industry.
On the other hand, Company B, a retail company purchasing items from Company A, has an ROE of 18%. If the retail industry has 21% as its average ROE, while Company B has a higher ROE than Company A, its ROE is lower than the industry average.
This scenario concludes that Company B does not use company equity as effectively as other companies in the retail industry.
Low and Negative ROE
Where a company has an ROE of less than 10%, then it has a low or negative return on equity. That is the simple way to look at it.
A company can undergo restructuring or make a significant purchase using a large portion of its shares. In that situation, there will be a Low Return on Equity. This means that the Return on Assets will be enough to offset whatever debts have been incurred. It even gets better because the assets acquired might increase in value over a long period.
In these situations, the company usually puts out a statement informing shareholders and the general public of their intentions and how it affects the ROE.
Can Return On Equity Be More Than 100?
The ROE levels of a firm can exceed 100%. Many wonder if this is a good thing or not. The answer, however, is – not necessarily.
A company’s ROE can be made uneven by high debt. Where that happens, it means the company is already in danger. In 2010, Tempur-Pedic reported an ROE of over 100%. On closer scrutiny, it was discovered that the company was $393 million in debt, with a liquidity of $38 million.
In essence, ROE can be reported at levels higher than 100. However, the financial context will play a role in its interpretation.
What Is an Ideal ROE?
An ideal Return on Equity is a variant percentage which shows that the company is in an optimum position financially. The idea of an ideal Return on Equity differs from industry to industry. Due to this, you will have to interpret ROE based on the situation in the industry. In general, ROEs of about 15-20% are generally considered to be ideal ROEs.
This means that for an ROE to be ideal, it must thrive in comparison to other companies in the same industry. If it does not do well in comparison, then it is less than ideal. If the debt exceeds the equity, and the Return on Assets (ROA) is higher in value, it is still ideal. This is because the ROA being higher than the debt means that the debt in question will be paid off.
How To Calculate Return on Equity
You can calculate Return on Equity by dividing the company’s net income by the shareholding equity average. It can also be applied to cover different periods and lengths of time, whether monthly, bi-monthly, or quarterly.
Net income is the total amount of money made within a fiscal period before any distributions and deductions are made. It is one of the significant indices showing a company’s position on the income statement.
Average Shareholder’s Equity
This refers to the amount of a company’s net assets belonging to the shareholders. The average shareholder’s equity is the equity available to the shareholder per dollar.
Example of Return on Equity
Company Sigma made an amount of $70 million in net income this year. Its average total equity is $140 million. The calculation for the ROE will be expressed this way:
Net income ÷Average Total Equity = ROE
$70,000,000÷$140,000,000 = 0.5
This means that for every $1, the return on equity is 0.50, making the percentage expression 50%.
What Else Is Return on Equity Used for?
Return on Equity is not only an indicator of a company’s viability for investment. It is used for a variety of reasons.
Estimate Growth Rates
A company’s Return on Equity can be used to predict and estimate growth rates. To determine a company’s growth rate, multiply the company’s retention ratio by the ROE. A retention ratio is the net income percentage reinvested or retained by the company to finance future growth.
Sustainable Growth Rates
Sustainable Growth Rate is the pace at which a company can realistically grow without seeking external funding in any form. This means that it is the test of how far a company’s internally generated revenue can take it. It is a good indicator of a company’s viability and liquidity.
Investors can predict and determine whether a company is healthy enough to be invested in. Investors can also ascertain the level of riskiness involved in investing.
Dividend Growth Rates
Dividend Growth Rates are the percentage rates of growth on dividends over a period of time. It is calculated annually as companies review the dividends paid to their investors upwards.
Firms may use Return on Equity to determine and predict dividend growth rates. It is also vital for the valuation of stocks.
How Do Companies Increase Return on Equity?
Companies can increase their Return on Equity in the following ways:
- By using more financial leverage
- By increasing the margins of profit.
- Improving asset turnover
- By distribution of excess cash amongst shareholders. This will help the company gain profitability when measured based on ROE.
- By payment of lower taxes and increasing profit rate as a result.
What Is the Difference Between ROI and ROE?
The difference between Return on Investment (ROI) and Return on Equity is solely based on focus.
ROI focuses on profitability majorly, while ROE pays attention to the effectiveness of management decisions.
Debt is factored in when calculating the Return on Investment of a company, while it is not factored when calculating the company’s Return on Equity.
Why You Should Consult a Financial Advisor
In conclusion, no investor should put his money down on any company without paying close attention to the Return on Equity. For this reason, you should always consult your financial advisor before you invest in any company, no matter how profitable it may look.