With many different and complicated financial calculations to choose from, what is ‘return on equity’ and how can it help us improve our investing game?
Oct. 2, 2020
Return on equity (or ROE) is a common measure of performance and profitability. For investors, it shows how well a company is doing financially and how well it might be utilizing the money that shareholders have invested in the firm. A return on equity can be used to analyse ‘the bottom-line’, as it pertains to profitability and shareholders who are one of the first financial obligations at the bottom of the firm’s capital hierarchy.
How to calculate the ROE
Return on equity is calculated by dividing a company’s net income by its shareholder equity. But in order to get to that point, both the shareholder equity and the net income must be found.
Shareholder equity is essentially how much is left over for owners to claim once debts and obligations have been paid. A simple way to do this is by taking the total assets, found on its balance sheets and subtracting its total debts/liabilities, also found on the balance sheets. The resulting number can be positive or negative meaning the company either has enough money to cover its debts, or it doesn’t. Either way, this number is the shareholder equity and it is needed to find the ROE.
The net income is calculated before the dividends are paid to its common shareholders and it comprises the total income minus its taxes and expenses for a given period. To find the ROE, the net income from the end of the period and the shareholder equity from the beginning must be taken and then divided. To get the most accurate ROE, it is considered good practice to make these calculations with the average shareholder equity taken throughout the period as there can often be differences between a company’s income statement and its balance sheet.
Why is return on equity useful?
Return on equity is weighted depending on the industry average. For example, the aerospace industry currently has an average ROE of 26% whilst the general utilities sector has an average of 5.9%. A company should be aiming for its industry average or higher as a way to show that it is managing its financials as well as, if not better than others within the same sector. A word to the wise however, a ROE below 10% is often considered poor, no matter the industrial average.
An ROE can also be used predictively. For many investors, the dividend is a good way to earn on an investment. By looking at the ROE and multiplying it by the dividend payout ratio, one can predict the dividend percentage for the coming period. In a similar strain, the ROE can also predict the sustainability of a company’s growth rate. This is done by multiplying the ROE by the retention rate (the percentage of its net income that is not paid in a dividend and is instead retained). The growth rate calculated shows how much the company is likely to grow in the future.
Return on equity is also good for highlighting problems with a stock that you might be interested in. If the ROE is unusually high, this can signal inconsistent profits, excess debt, or negative net income. When the ROE is much higher than the industrial average it is always good to dive into the balance sheets to take a harder look at the debts or expenses a company might have.
Things to keep in mind
ROE is not the be-all or end-all for measuring a company’s effectiveness. When calculating the ROE for a company that has non-monetary assets such as trademarks and patents, then the process becomes a lot harder to compare to other companies within the same industry.
There are other measures which do different things, such as return on investment capital (ROIC), which takes the ROE calculations a few steps further and analyses how well all sources of income are utilized after the dividend payment.
In the event of a negative ROE, aside from the multiple problems that it highlights with debt and equity, it can no longer be used as a comparison tool and it would be advisable to find a different tool to highlight and compare a company’s growth and profitability.
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