Return on Equity (ROE) – Meaning, Calculation and Example
What is Return on Equity (ROE)?
Return on equity (ROE) is a financial metric that indicates a company’s performance by calculating how much a shareholder earns from his shares in the company. It is a percentage that is determined by dividing the net income of the company by the total equity of the stakeholders.
The return on equity formula can also be computed by dividing the company’s dividend growth rate by its rate of retained profits. The ROE ratio indicates a company’s potential to earn returns on the capital that is invested by its owners.
How Does Return on Equity Work?
Return on Equity (ROE) is a financial ratio that compares a company’s profitability to the amount of shareholder equity invested in the company. It is calculated by dividing a company’s net income by the amount of shareholder equity it has. In other words, ROE assesses how effectively a company generates profits from funds invested by its shareholders. A higher ROE indicates that a company is making more money per unit of shareholder equity, which is generally a good thing for investors.
However, because ROE can be influenced by a variety of factors such as debt, taxes, and industry norms, it should be considered in conjunction with other financial ratios and factors.
ROE Formula
The Return of Equity Formula Ratio is:
Return on Equity (ROE) = Net Income / Shareholder’s Equity
Where,
- Net Income = Total Revenue – Cost of Goods Sold- Operating Expenses- Interest Payable – Taxes
- Shareholder’s Equity = Total Assets – Total Liabilities or Share Capital + Retained Earnings + Other Reserves
- Total Assets = Tangible Assets + Intangible Assets
How to Calculate Return on Equity?
Analysts calculate ROE by using the ROE formula. Let’s understand with an example:
Let’s say your company has a net income of Rs 120,000 and shareholders’ equity of Rs 800,000. Use the ROE formula to calculate your company’s return on equity ratio for the period:
- ROE = Rs120000 / Rs800000
The ROE or return on equity is 0.15 or 15%.
Assume your net income increases during the next period to Rs160000 and your shareholders’ equity remains unchanged i.e. Rs 800,000.
- ROE = Rs 160,000 / Rs 800,000
The ROE or return on equity for the period is 0.2 or 20%.
Generally the higher your return on equity ratio, the better it is. Investors prefer to see a high ROE since it suggests that the company is making good use of its resources. A return on equity of 15-20% is generally seen as satisfactory. However, depending on the industry, a good ROE can vary.
Example of Return on Equity
The value of Return on Equity is subjective and is determined by what is usual among a company’s competitors. For example, a company in a particular sector has many assets and debts but less net income on its financial statement. Considering this an ROE in this industry could be 15% or less. On the other hand, a technological company whose assets and debt accounts are smaller as compared to the net income may have a typical return on equity of 20% or higher.
ROE ratios will differ depending on the type of industry group or sector of the business. A company should always aim for an ROE that is equal to or higher than other companies in the same sector and industry. For instance, if X company’s ROE is 18% and the other A company’s ROE is 15% then it represents that X company’s management is above average at generating profits from the company’s assets.
Interpreting the Metrics of Return on Equity
After using the return on equity formula the resulting number can be interpreted as mentioned below:
- The higher the ROE, the more effective management is at generating income and growth from equity financing. A very high ROE is a good thing if a company’s net income is particularly substantial in comparison to its equity. However, an extraordinarily high ROE is frequently due to a small equity account in comparison to net income, indicating risk.
- If a company’s ROE is negative or lower than its peers, it signifies that it had a loss during the time. This suggests that stockholders are losing faith in the company. A negative ROE may be expected for new and expanding businesses; but, if a negative ROE continues to be a norm, it can be an indication of problems.
What is an Ideal Return on Equity?
There is no one-size-fits-all answer to what an ideal return on equity (ROE) is because it varies depending on the industry, the stage of growth of the company, and other factors. However, as a general rule, a higher ROE is considered better because it indicates that a company generates more profits per unit of shareholder equity. ROE values above 15% are generally considered good, while those above 20% are frequently regarded as excellent. What is considered an ideal ROE, however, can also be influenced by factors such as a company’s risk profile, growth prospects, and cost of capital.
Here are some examples of situations where a high ROE may indicate a negative impact on the business:
1. Increased Debt Can Appreciate ROE
Because debt is less expensive than equity financing, increased debt can improve return on equity (ROE). When a company uses debt financing to expand or invest in its operations, it can increase net income without increasing shareholders’ equity, resulting in an increase in ROE. This is due to the fact that debt interest is tax-deductible, lowering the company’s tax liability, whereas dividends paid to equity shareholders are not. However, relying too heavily on debt financing can increase the company’s financial risk, especially if interest rates rise and make meeting debt obligations more difficult. As a result, while using debt to increase ROE can be beneficial, it must be balanced with prudent financial management and a long-term business plan.
2. Declining Equity Investment
Declining equity investment refers to a situation in which a company’s equity investment decreases over time. This could be due to a number of factors, including a drop in stock price or a decrease in the number of shareholders. When equity investment falls, the company’s return on equity (ROE) rises because the denominator in the ROE formula (shareholders’ equity) falls. However, a decrease in equity investment does not always imply increased profitability. It could be an indication of underlying problems such as dwindling investor confidence, poor financial performance, or mismanagement. As a result, it is critical for businesses to strike a balance between equity and debt financing in order to ensure financial stability and long-term growth.
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Benefits of Return on Equity
Here are a few advantages of return on equity for investors and companies:
- The ROE computation is one of the most basic financial ratio calculations. It can also be used to make investment decisions in that it is simple but effective.
- It can help in increasing the number of investors. Investors want to know how much revenue the company may acquire. The return on equity ratio is an evaluation that compares a company’s profit to its total shareholder equity. If the ratio is higher more investors will be drawn to it.
- ROE can also be used by shareholders to evaluate management performance.
- It enables investors and analysts to assess all possible investment prospects quickly, saving both time and money.
- Possible returns on different types of investment options can be measured with the help of ROE.
- It also aids in assessing and analysing the advantages of investing in a particular sector.
- It is useful for assessing competitive businesses in the same industry type or sector.
Limitations of Return on Equity
Below mentioned are a few disadvantages of Return on Equity:
- The time factor is completely neglected in ROE calculations, which is a significant disadvantage of this financial metric.
- Multiple ROE calculating processes can result in conflicting opinions and confusion. A business may use a different method while an investor can use a different method to compute the Return on Equity ratio.
- When doing a comparison between different companies, every firm must use the same accounting principles and methods for calculating the value of the stock, fixed assets, overhead apportionment, and so on.
- Intangible assets or non-monetary commodities may be excluded from shareholders’ equity in some ROE measures. These include assets such as trademarks, licences, and so on. As a result, assessments could be inaccurate and difficult to compare to other organisations that have opted to include these intangible assets.
Difference Between the Rate of Return and Return on Equity?
| Rate of Return (ROR) | Return on Equity (ROE) |
| The rate of return, or RoR, is the net gain or loss on a long-term investment. It is stated as a percentage of the investment’s principal. | Return on equity (ROE) is a method for evaluating financial performance that is calculated by dividing net income by shareholders’ equity. |
| You can calculate the Rate of Return by using:ROR = [(Current value-initial value)/Initial value]*100 | You can calculate Return on Equity by using:ROE = [Net income/Average shareholder’s equity] |
| ROR is used to measure the profit or loss suffered in investment over time. | ROE is used to measure a business’s profitability and how efficiently it can generate those profits. |
Is ROE a Good Scale to Use?
The Return on Equity ratio is concerned with the net income return from the shareholders’ investment. If you are a shareholder, this provides you with a quick and simple metric. However, if investors are not taking the required precautions, it can deflect focus away from business essential principles. Investors must comprehend the factors that contribute to the company’s growth as well as to its profitability. This is why financial analysts use different financial metrics.
Despite its few drawbacks, it gives information about how the company uses its capital assets. Financial specialists and investors use this metric to determine whether or not capital is being used effectively. This is essential information for investors. Companies that have good financial management attract more investors. They are more likely to succeed even in financial stringency.
Impacts of High ROE and its Indications
High return on equity (ROE) can have several positive impacts on a business, such as:
1. Attracting Investors
A high ROE is often seen as a sign of a profitable and well-managed business, which can attract new investors and increase the company’s stock price.
2. Competitive Advantage
Can indicate that the company is generating more profit per dollar of equity than its competitors, which can give it a competitive advantage.
3. Increased Borrowing Capacity
Makes it easier for a company to borrow money, as it indicates a strong financial position and the ability to repay debt.
However, a high ROE may not always be a positive sign for a business. It could also indicate underlying issues such as:
4. Risky Investments
A company may be taking on risky investments with the potential for high returns, but also high losses.
5. Overleveraging
A high debt-to-equity ratio can increase a company’s ROE, but also increase its financial risk and the likelihood of defaulting on debt.
6. Unsustainable Growth
A company may be growing its earnings through unsustainable methods, such as excessive cost-cutting or aggressive accounting practices.
List of High ROE Stocks in India
| Company | Average 5 years |
| Hindustan Unilever Ltd. | 53.08 |
| Nestle India Ltd. | 77.62 |
| Colgate-Palmolive (India) Ltd. | 101.66 |
| Procter & Gamble Hygiene and Health Care Ltd. | 60.69 |
| Coal India Ltd. | 45.66 |
| Page Industries Ltd. | 44.28 |
| Marico Ltd. | 35.19 |
| Britannia Industries Ltd. | 40.14 |
| Tata Consultancy Services Ltd. | 36.89 |
| Tata Elxsi Ltd. | 22.67 |
| Bharat Petroleum Corporation Ltd. | 21.15 |
Final Word
Return on Equity measures how a company generates its profit. Analysts compute Return on Equity to evaluate a company’s financial performance. A higher ROE means that the company is better at converting equity financing into profits. ROE varies depending on the industry or sector in which the company works. Understanding ROE can help you generate a smart investment strategy. Before determining where to put your money, take a look at how companies operate to attain their good ROE and compare companies within the same industry and sector.
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FAQs
Return on Equity is calculated using the following formula:
-Net Income / Shareholder Equity = Return on Equity
The income statement includes net income, also known as net profit. It displays the total profit remaining after deducting the cost of items sold, operational expenses, and any other expenses.
A rising ROE indicates that a corporation is expanding its profit generation while using less capital. It also shows how well a company’s management uses shareholder funds. A greater ROE is normally preferable, however, a declining ROE may suggest inefficient use of equity capital.
It features numerous accounting flaws that might mislead reported earnings. Because accounting standards change and interpretations differ, net income is not always comparable over time or among firms.
5 ways to increase your Return on Equity
-Increase your financial leverage. Companies can fund themselves using both debt and equity.
-Increase your profit margins.
-Increase asset turnover.
-Distribute unused funds.
-Reduced taxes.
If a company’s ROE is negative, it signifies that it had a loss during the time period considered. This suggests that stockholders are losing faith in the company. A negative ROE may be expected for new and expanding businesses; but, if a negative ROE persists, it can be an indication of problems.
The full form of ROE is Return on Equity.
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This article has been prepared on the basis of internal data, publicly available information and other sources believed to be reliable. The information contained in this article is for general purposes only and not a complete disclosure of every material fact. It should not be construed as investment advice to any party. The article does not warrant the completeness or accuracy of the information and disclaims all liabilities, losses and damages arising out of the use of this information. Readers shall be fully liable/responsible for any decision taken on the basis of this article.
