What is Return on Equity?
Return on Equity is a financial ratio that tells us about the performance of a particular stock. It signifies the rate of return that the owner of an equity share receives on its shareholding. In essence, it indicates the potential of the company to turn the equity investments of the shareholders into profit.
Formula to Calculate Return on Equity
The mathematical formula for calculating Return on Equity is as follows:
Return On Equity = Net Income / Shareholder’s Equity
Net Income is the total income earned by the firm in a given period of time. The denominator, i.e., the shareholder’s equity is the difference between a firm’s assets and liabilities. It is the amount left, when a firm sells off all its assets and pays off all its debts and other liabilities.
For instance, if a firm has a ROE as Rs. 2. This essentially means that each rupee of common shareholder’s equity earned Rs. 2. In other words, the shareholders of the company saw 200% return on their investment. Such a high ROE ratio indicates that the firm is in its growth stage. Investors should take up the average of the ROEs for the past 5 to 10 years, to get a better picture of the company’s growth.
It should also be noted that the higher ROE, indicating high growth, may not be entirely passed onto the investors. The firm may decide to reinvest the profits.
What does the ROE of a firm reflect?
- It is a simple tool to evaluate the investment returns of the firm in question.
- When we compare the firm’s ROE to that of the industry average and its historical ROE, we can assess the competitive advantage that the firm has to offer. We cannot decipher much from the metric, if we look at it in isolation.
- ROE as a metric also gives investors an understanding of how the business management plans to use the equity financing, for the growth of the business.
- An increasing ROE over a course of time is considered good, as it means that the firm is well-equipped at generating shareholder value. It may be reinvesting its profits prudently, in order to enhance productivity and efficiency in the business. A declining ROE over time may reflect the bad management decisions and allocation to unproductive resources.
- A company;s equity is considered a good investment if the ROE of that company is higher than the returns from a lower risk investment.
- It has been noted that cyclical industries such as automobile, construction, etc., have higher ROEs when compared to defensive industries such as
Drawbacks of Using ROE as an Indicator of Profitability
- Sometimes, a firm may have a higher ROE because of higher debt, not because it is profitable. High debt financing implies less equity financing, which means that the value of denominator (shareholders’ equity) will be less, thus increasing the overall value of ROE. This can be misleading to investors who can confuse this for high profitability. An investor should also look at other variables before investing in a specific company.
- The formula of ROE can also be manipulated by buying back shares. When the business purchases back its shares from shareholders, it reduces the value of shareholders’ equity. Again, the overall value of ROE increases as the denominator decreases.
- Also, while comparing ROEs of different firms, one should also look at the inclusion of different variables. Some firms may choose to include intangible assets such as intellectual property, copyrights, etc in shareholders’ equity, while others may exclude it. This can make comparison of ROEs more confusing.
