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Finance 101: Understanding Return on Equity (ROE)

by gbaf mag
Finance 101: Understanding Return on Equity (ROE)

Everyone wants a good return on their investment. That’s a given! But the question is if one knows the right factors that can help them get a bang for their buck. ROE – the ratio of net income and shareholder equity, is one such factor that tells us whether a business is running in profit or not. Read on to know more about ROE and some interesting investment tips.

In this article we will discuss:

  1. What is Return on Equity?
  2. How to Calculate Return on Equity
  3. How to Invest Better
  4. Alternatives to ROE
  5. Drawbacks of ROE
  6. Additional Resources

What is Return on Equity?

Return on Equity (ROE) is a ratio of Net Income of a company and Shareholder Equity. This ratio is considered by the investors while forming an insight into the efficiency of the company (especially its leadership team) in handling the money shareholders have contributed to it. In simpler terms, it helps judge the profitability of an institution concerning stockholder’s equity. The higher the ROE, the more structured a company’s leadership is at making money and expanding from its equity financing. The ROE is commensurate with the profit and growth statistics of a company.

Mostly, ROE is used to compare a company to its competitors and assess its market worth. This plays a very significant role while comparing companies of the same industry since it gives accurate measures of companies performing well and operating with high financial efficiency. Also, ROE is greatly valued for examining companies with tangible assets.

Return on Equity Formula

There’s a very simple formula for evaluating ROE of a business.

ROE = Net Income / Shareholder Equity

​The net income or Free Cash Flow (FCF) is basically the bottom line profit (i.e. the company’s income post deduction of expenses from revenues) before stock dividends are paid.

Shareholder Equity (SE), also referred to as stockholders’ equity, is the corporation’s owners’ residual claim after debts are paid or cleared off. Equity is equal to a company’s total assets minus its total liabilities.

Note: ROE and Return on Total Assets (ROTA) are two different measures. ROTA is also a profit detector. It is calculated by dividing a company’s Earnings Before Interest and Taxes (EBIT) by the company’s total assets.

Time-to-time analysis of ROE and its change in values can help in getting a company’s overall growth trajectory. Using the same, investors can find a firm’s year-on-year, quarterly, or monthly growth rate. The management’s performance and the success of specific leadership experiments can also be tracked using ROE.

How to Invest Better

Investing is a risky business. No matter what you invest in, there are always risks associated with it. That’s why we recommend that you get professional advice from companies such as Personal CapitalScottish Friendly, or Motley Fool before investing.

The first lesson before investing is comparing industries to the overall market. This will give you a clear idea about which sector should you go to. More precisely, which sector is expected to boom in the future.

Taking an example – the ROE of the entire stock market as measured by the S&P 500 was 15.25% in the 1st quarter of 2020. Let’s suppose, ROE listed by industry are showing that the stocks of Sector A are performing not so well as compared to Sector AA. The ROE figures of Sector AA are 26.1%, while other sectors like Sector A and Sector B have 7.23% and 8.18%, respectively. This indicates that the firms in Sector AA are performing way better than other firms. It also shows Sector AA has a steady growth rate which means, it is giving good returns to its investors.

The second lesson involves taking a careful look at the firms present in Sector AA, comparing their ROEs with the market as a whole, and with firms from the same industry. For instance, if Firm AA1 reports a net income of $5 billion and total shareholders’ equity of $50 billion, its ROE will stand at $5 billion ÷ $50 billion = 10%

Quite simply, it means for every dollar of shareholders’ equity Firm AA1 generated a profit of 10 cents.

This way, you can arrive at a wise conclusion while looking to invest in stocks.

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It isn’t always simple!

Calculating ROEs can get tricky at times. Especially when you are calculating a firm’s ROE against its sector, you have to be a little more cautious.

For example, in the fourth quarter of 2019, if Bank A had a ROE of 9.36%, and as per the Federal Deposit Insurance Corporation (FDIC), the average ROE for the banking industry during the same period was 13.03%, it means Bank A did not perform well in the industry. However, the FDIC calculations were based on all banks, including commercial, consumer, and community banks. And, the ROE for commercial banks was 5.03% in the third quarter of 2019.  Since Bank A is also a commercial lender, its ROE was above that of other commercial banks.

The conclusion is rather simple: you need to compare the ROE of a firm to the industry average and also to similar firms within that industry. For detailed lessons on trading in stocks and the likes, check out Trading Lesson and Rocket Dollar.

Alternatives to ROE

Investors use various tactics to measure the growth rate of a company. Return on capital employed (ROCE) and return on operating capital (ROOC) are a few of the methods usually in practice. ROCE is used over ROE while assessing the longevity of a company. In our opinion, both serve well in capital-intensive businesses like automobile manufacturing, oil production, and refining, steel production, telecommunications, and transportation sectors.

Cyclical industries tend to generate higher ROEs than defensive industries, which is due to several risk factors attributable to them. A firm that is riskier in its approach will have a higher cost of capital and a higher cost of equity. The cost of equity is the return a firm pays to its shareholders, to compensate for the risk shareholders’ undertake by investing their capital.

It is always considered better to compare a firm’s ROE to its cost of equity. A firm with a higher return on equity than its cost of equity has added worth.

Drawbacks of ROE

The return on equity can be sabotaged by share buybacks. Generally, when management repurchases its shares from the market, the number of outstanding shares reduces. This affects the ROE. The ROE increases as the denominator shrinks, while in actuality, that’s not the case.

Sometimes ROE ratios exclude intangible assets from stockholders’ equity. Intangible assets are always non-monetary items. They include significant deciding factors such as goodwill, trademarks, copyrights, and patents. This results in misleading ROE calculations, and it becomes very difficult to compare the ROE  to other firms that have chosen to include intangible assets.

The ROE ratio includes variations in its composition. For example, the shareholders’ equity is never accurate, and the net income may also be substituted for EBITDA and EBIT, it is adjusted, sometimes not adjusted for non-recurring items.

Wrap Up!

Hope the understanding of ROE will help you arrive at better business decisions and see through the alarming times. Making money is always about calculative moves, or should we say calculated ROEs!