Return on Equity (ROE) is a financial ratio that is used to assess a business’s net income relative to the value of shareholder’s equity. It is used in various ways to analyze profitability and growth.
In this post we will cover what Return on Equity is, how it is calculated and how it is used to analyze growth and efficiency.
What Is Return On Equity (ROE)?
Return on equity is a type of financial ratio that helps analysts understand how efficient a business is at using its net assets to generate profit for the business. It is important to remember that net assets are equal to shareholder equity (Assets-Liabilities=Equity). It is often used in profitability analysis and as a way to model future performance.
The flexibility of the ratio is a result of taking the practical approach of asking how much net income is produced for every dollar of equity invested.
How To Calculate Return On Equity (ROE)?
Return on Equity (ROE) is calculated by taking the net income from the income statement and dividing it by the value of shareholder’s equity on the balance sheet. The resulting value is expressed in terms of percentages and because of this both net income and equity must be positive to get a useful output. Use the formula below to calculate ROE:
Where, Shareholder Equity is equal to the following:
How Is Return On Equity Used?
Analysts use Return on Equity for a variety of purposes, but like all financial ratios it must be taken into context against the industry the business participates in. This is one of the key benefits of using financial ratios when performing financial analysis. Ratios make it easy for analysts to compare multiple businesses within the same sector.
Whether or not the ratio is “good” depends upon a variety of factors including, stage of growth, industry standards, and age of the business. In order to understand what drives a high ROE let’s take a closer look at its components.
Using Return on Equity In The Sustainable Growth Rate Model
Net income is the numerator in the equation. This means holding equity equal the higher net income is, the higher the resulting percentage. Understanding this concept helps to understand why Return on Equity is used as a growth metric.
Analysts use ROE in conjunction with another ratio, the retention ratio, to approximate the future growth rate of a business. As a reminder, the retention ratio is the percentage of net income a business withholds from equity holders to reinvest in itself for the purpose of growth. The resulting formula is:
The resulting growth rate can be calculated across different businesses in the same industry and then used as a metric of comparison in a type of analysis called the Sustainable Growth Rate Model.
Using Return on Equity To Measure Efficiency
Analyzing ROE further helps to assess whether a very high or low ROE is good or bad. It stands to reason that a high ROE is best, but that might not be the case. Referring to the formula, holding net income equal the lower equity goes the higher the resulting percentage.
Looking back on the accounting equation (Equity = Assets – Liabilities) makes it clear that there are two factors at play when ROE is high but net income is stable. If liabilities are stable between periods then the declining equity value is likely a result of a decline in assets. Conversely, if assets remain relatively stable between periods then that means liabilities, namely debt, have risen.
ROE When Net Income Is Negative
When net income is negative the resulting percentage is negative, which is always considered bad. If both net income and equity are negative the resulting ratio might be artificially inflated and misleading. This is why the general rule of thumb is to not rely on ROE when net income or equity are applicable.
Return On Equity Drawbacks
One of the confusing aspects of ROE is that high numbers might not be good. That means it cannot be relied upon as a quick method to analyze a business. In fact, the larger ROE is the more it indicates that the business requires further investigation as to what the cause is.
In addition, the formula is not useful in circ*mstances where net income or equity is negative. This is because a business with a negative ROE cannot be effectively compared to other businesses in the same industry that have positive ROEs.
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