Return on Equity (ROE)

Evaluates the returns on a company compared to the size of its equity

What is Return on Equity (ROE)?

Return on Equity (ROE) is a measure of a company’s annual return (net income) divided by the value of its total shareholders’ equity (i.e. 12%). Alternatively, ROE can also be derived by dividing the firm’s dividend growth rate by its earnings retention rate (or, 1 – dividend payout ratio).

Return on Equity is a two-part ratio that brings together the income statement and the balance sheet as the net income or profit is compared to the shareholders’ equity. The number represents the total return on equity capital and shows the firm’s ability to turn assets into profits. To put it another way, it measures the profits made for each dollar from shareholders’ equity.

Return on Equity formula

 

Return on Equity formula

The following is the ROE’s equation:

ROE = Net Income / Shareholder’s Equity 

 

ROE simplifies comparison of return. By comparing it to the industry’s average, it may reveal a company’s competitive advantage. Another insight is how the management is using the financing from equity to grow the business. A sustainable and increasing ROE over time can mean a company is good at generating shareholder returns because it knows how to reinvest its earnings in productive and high-quality assets.

In contrast, a declining ROE means that management is making poor decisions on investing capital in unproductive assets. Market price is affected by the changes in the book value (shareholders’ equity), so if ROE remains small even when the company is retaining those earnings the then market price will reflect that small change in the book value. This is not a good sign for the company.

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Why is ROE important?

With net income in the numerator, Return on Equity (ROE) looks at the firm’s bottom line to gauge overall profitability for the firm’s owners. Stockholders are at the bottom of the pecking order of a firm’s capital structure, and the income returned to them is a useful measure that represents excess profits that remain after paying its mandatory obligations and after reinvesting in the business. There are two ways to return capital to shareholders; net income that is not paid out in the form of dividends is retained by the firm in the form of retained earnings in shareholders’ equity.

 

ROE Formula

 

 

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Why use the Return on Equity metric?

With ROE, Investors can see if they’re getting a good return on their money, while a company can evaluate how efficiently they’re utilizing shareholder’s equity. ROE must be compared to the historical ROEs of the company and to the industry’s ROE average, as it would mean nothing if used in isolation. Other investments can be looked at such as the return on a bank to compare and decide if it’s worth the risk of investing in a company. A company should be able to generate a higher ROE than a return in a lower risk asset to convince investors. Just like most financial ratios, ROE must be combined with other ratios to get a better overview of a company’s financial health and performance. For instance, a low Price-to-Book ratio and a rising ROE can be a cheap buy and perhaps a good investment. Additionally, if an investor wants to delve deeper into the company’s financials, ROE is a starting point to perform a Du Pont Analysis.

 

Effect of Leverage

A high ROE could mean a company is more successful in generating cash internally. However, it doesn’t fully show the risk associated with that return. A company may rely heavily on debt to generate an outstanding net profit, thereby boosting the ROE higher.

As an example, if a company has $150,000 in equity and $850,000 in debt, then the total capital employed is $1,000,000. This is the same number for total assets employed. At 5%, it will cost $42,000 to service debt, annually. If the company manages to increase its profits before interest at 12% of assets employed, the remaining profit after paying the interest is $78,000, which will increase equity by more than 50%, assuming the profit gets reinvested back. As we can see, the effect of debt is to magnify the return on equity.

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Drawbacks of ROE

The return on equity ratio can be skewed by share buybacks. When management repurchases its shares from the marketplace, this reduces the number of outstanding shares. Thus, ROE increases as the denominator shrinks.

Another weakness is the ratio tells little about when the return will turn into cash and dividends. Some ROE ratios may exclude intangible assets from shareholders’ equity. Intangible assets are non-monetary items such as goodwill, trademark, copyrights and patents. This can make calculations misleading and difficult to compare to other firms that have included intangible assets.

Finally, the ratio includes some variations on its composition, and there may be some disagreements between analysts. For example, the shareholders’ equity can either be the beginning, ending or the average of the two, while Net Income can be substituted for EBITDA and EBIT, and can be adjusted or not for non-recurring items.

 

How to use Return on Equity

Some industries tend to achieve higher ROEs than others, and therefore, ROE is most useful when comparing companies within the same industry. Cyclical industries tend to generate higher ROEs than defensive industries, which is due to the different risk characteristics attributable to them. A riskier firm will demand a higher cost of capital and a higher cost of equity.

Furthermore, it is useful to compare a firm’s ROE to its cost of equity. A firm that has earned a return on equity higher than its cost of equity has added value and vice versa. The stock of a firm with a 20% ROE will generally cost twice as much as one with a 10% ROE (all else being equal).

 

The DuPont Formula

The DuPont formula breaks down ROE into three key components, all of which are insightful when thinking about a firm’s profitability. ROE is equal to the product of a firm’s net profit margin, asset turnover, and financial leverage:

 

DuPont Formula for Return on Equity

 

If the net profit margin increases over time, the firm is managing its operating and financial expenses well and the ROE should also increase over time. If the asset turnover increases, the firm is utilizing its assets efficiently, generating more sales per dollar of assets owned. Lastly, if the firm’s financial leverage increases, the firm can deploy the debt capital to magnify returns.

 

Major caveats of Return on Equity

While debt financing can be used to boost ROE, it is important to keep in mind that overleveraging has a negative impact in the form of high-interest payments and increased risk of default. The market may demand a higher cost of equity, putting pressure on the firm’s valuation. While a debt typically carries a lower cost and the benefit of tax shields, the true value is created when a firm finds its optimal capital structure that balances the risks and rewards of financial leverage.

Furthermore, it is important to keep in mind that ROE is a ratio, and the firm can take actions to artificially boost ROE by decreasing shareholders’ equity (the denominator). For example, asset write-downs and share repurchases are actions that reduce the value of shareholders’ equity.

 

Additional resources

This has been a guide to return on equity, the return on equity formula, and pro/cons of the metric.  To keep learning and expanding your financial analyst skills, see these additional valuable resources: