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Return on equity (ROE) is a financial ratio that tells you how much profit a public company earns in comparison to the net assets it holds. ROE is very useful for comparing the performance of similar companies in the same industry and can show you which are making most efficient use of their (and by extension their investors’) money.
What Is ROE?
Return on equity is a ratio of a public company’s net profits to its shareholders’ equity, or the value of the company’s assets minus its liabilities. This is known as shareholders’ equity because it is the amount that would be divided up among those who held its stock if a company closed. In this scenario, first a company would have to pay back its debts, or liabilities, and then the remainder of its assets would be spread among the shareholders.
By comparing a public company’s net earnings to its shareholders’ equity stakes, ROE helps you understand how efficiently a firm is using its investors’ money to generate profits. In other words, ROE shows how much in profit the company earns from each dollar of shareholders’ equity, expressed as a percentage.
A company with decent ROE tells you that buying its stock will likely be a lucrative investment over the long term. ROE is closely related to measures like return on assets (ROA) and return on investment (ROI).
How to Calculate ROE
The basic formula for calculating ROE simply asks you to divide net earnings from a given period by shareholder equity. The net earnings can be found on the earnings statement from the company’s most recent annual report, and the shareholder equity will be listed on the company’s balance sheet. The specific ROE formula looks like this:
ROE = (Net Earnings / Shareholders’ Equity) x 100
Here’s how that plays out: Let’s say that company JKL had net earnings of $35,500,000 for a year. During that time, the average shareholders’ equity was $578,000,000.
To determine JKL’s return on equity, you would divide $35.5 million by $578 million, which would give you 0.0614. Multiply by 100, and make it a percentage you get 6.14%. This means that for every dollar in shareholder equity, the company generates 6.14 cents in net income.
How to Use ROE
ROE can help you understand a public company’s financial health. It’s difficult to compare ROE across industries, although comparing a given company’s ROE to the average in its industry shows you how well a company does at generating profits compared to its peers.
A good use case is comparing a company’s ROE over time to understand whether it’s doing a better or worse job delivering profits now than in the past. If the firm’s ROE is steadily increasing in a sustainable manner—increases are not sudden or really huge—you might conclude that management is doing a good job. But if its ROE is decreasing over time, that could suggest that management is struggling to make the best decisions for the company’s bottom line.
What Is a Good ROE?
What makes for a good ROE depends on the specific industry of the companies involved. That’s because different types of companies have varying levels of assets and debts on their balance sheets and differing levels of income.
It would not be fair to compare a company with high asset and debt needs and lower typical income, for instance, with one that has lower needs for assets and debts and generally expects higher income.
That said, a good ROE is generally a little above the average for its industry. NYU professor Aswath Damodaran calculates the average ROE for a number of industries and has determined that the market averaged an ROE of 8.25% as of January 2021.
ROE vs. ROA
Return on equity is often used in conjunction with return on assets, a measure of a company’s net profit divided by its total assets. If this sounds similar to ROE, it’s because the formulas are almost identical—except for the fact that ROE considers debt when assessing how well a company generates profits.
Taken together, ROE and ROA can help you determine how well a company is making use of its debt. For instance, while ROE will almost always be higher than ROA when a company has taken on debt, if the difference is huge, this could suggest the company is not making good use of its borrowed dollars. This might spell trouble for a company later on.
Limitations of ROE
While helpful, ROE should not be the only metric used to gauge a company’s financial health and prospects. When taken alone, there are a number of ways that the ROE calculation can be misleading.
A company that aggressively borrows money, for instance, would artificially increase its ROE because any debt it takes on lowers the denominator of the ROE equation. Without context, this might give potential investors a misguided impression of the company’s efficiency. This can be a particular concern for fast-expanding growth companies, like many startups.
Similarly, if a company has several years of losses, which would reduce shareholder equity, a suddenly profitable year could give it a high ROE, simply because its asset-based denominator has shrunk so much. The underlying financial health of the company, however, would not have improved, meaning the company might not have suddenly become a good investment.
That’s why to gain a 360-degree view of a company’s efficiency, ROE must be viewed in conjunction with other factors, like ROA and ROI.
