Return on equity (ROE) is effectively the return on a company’s net assets. It is often used to compare a company’s profitability with its direct competition and/or companies in other industry sectors.
Examples of return on equity (ROE)
The calculation for return on equity is:
ROE = Net Income/Average Shareholders’ Equity
When applying the ROE formula, it’s important to ensure you use the average shareholder’s equity and net income from the same period. To calculate this, take the shareholders’ equity from the start and end of the period, add them together and divide by two.
ROE should only be calculated provided that the net profit and the average shareholders’ equity are both positive. If either is negative, the ROE may appear to be high but the figure will be misleading, so should be ignored.
The importance of return on equity
ROE is often one of the first points investors check when assessing a company’s profitability. Part of the reason it’s so useful is that it’s calculated using two key performance indicators: net income and average shareholder equity.
Net income is shown on a company’s profit and loss statement. It’s the income a business has left over after all its expenses have been paid, and is what is left over for the company and its ownership. Many investors will also be interested in knowing the split between operating expenses (such as cost of goods sold) and non-operating expenses such as debt.
ROE is one of the three main ratios used by investors to calculate how much benefit they can expect to get for their money (the other two are earnings per share and dividends).
The practicalities of return on equity
In general, ROE is used to compare like with like. Looking at the ROE of a prospective investment and comparing it to its competition can tell investors a lot about how well the company is doing.
When two companies are in the same sector, they will be dealing with similar business conditions. In some sectors, luck can be a factor. For example, in energy, one company may strike lucky and find an unexpectedly rich deposit of resources. Overall, however, luck tends to even out over time. This means that ROE is genuinely a fair measure of a company’s management.
When two companies are in different sectors, they will be dealing with different business conditions. The ROE could still potentially be useful in determining which sector offers better investment prospects. However, it still needs to be used with great care. For example, energy typically has a much lower ROE than technology but can also offer more stability.
Return on equity and shareholder returns
As a rule of thumb, a company’s ROE is a decent indicator of its ability to make returns to shareholders. Likewise, a company’s ability to make returns to shareholders will generally have a strong influence on its share price.
That said, a high ROE is no guarantee a company will feel able to pay generous dividends. For example, if a company has debt, it may choose to use its income to pay down that debt. This would reduce its potential liability for interest expense and hence potentially improve its performance over the longer term.