Return on Equity (ROE) and Calculating It

Furthermore, it is often the case that a company’s financial dynamics change throughout the year. If you take the shareholders’ equity from too narrow a timeframe, you may get a skewed result. More often than not, you can get a more accurate ROE if you use the average shareholders’ equity from multiple periods.

The ROE formula

What is an ideal Return on Equity (ROE)?

The ROE is a measure of how well a company is performing within its own sector, as compared to its competitors. In the utilities industry, companies tend to have high assets and debt and lower profits, so 10% or less may be normal. Tech and retail have smaller balance sheets and bigger earnings, so their idea of a good ROE may be 18% or higher.

What you’re looking for is a number that’s above average for the industry.

The difference between Rate of Return and Return on Equity

People often mix up the rate of return (RoR) and return on equity (ROE), but they actually measure different things. Here’s a comparison to clarify their differences:

If an investor wants to assess the profitability of their overall investment, they’d look at RoR. If they want to evaluate how well a company is using its equity, they’d check the ROE.

Using Return on Equity (ROE) to evaluate stock performance

ROE is also used to figure out how fast a stock might grow, including how its dividends might increase. This works best if the ROE is about the same or a bit higher than that of other similar companies.

Predicting future growth

To estimate how fast a company will grow, you can combine Return on Equity with another metric called the retention ratio. This ratio shows what portion of the company’s profit is kept and used to fund future growth.

Sustainable growth rate

If you have two companies with the same ROE and profit but different retention ratios, they will have different growth rates. The sustainable growth rate tells you how fast a company can grow without needing extra funds. To calculate the SGR, multiply the ROE by the retention ratio (or ROE by one minus the payout ratio).

Example

If a company is growing slower than its estimated sustainable rate, it might be undervalued or facing risks. Conversely, if it’s growing much faster, it’s worth looking into further.

Using Return on Equity (ROE) to identify risks

Suppose a company has an unusually high ROE. Sure, a strong ROE is usually a positive indicator, but it might also suggest some underlying risks that require closer examination.

Potential for negative net income

A company could be showing negative net income alongside negative equity. This combination leads to a misleadingly high ROE. To spot this, check that both net income and shareholders’ equity are positive.

Profit irregularities

Another red flag might be profit irregularities. Imagine a company that has faced losses for several years but suddenly reports a significant net income with low equity. This could create an inflated Return on Equity that doesn’t accurately represent the company’s overall performance.

You should then look at the company’s income history to determine if the high ROE is an anomaly or part of a consistent pattern.

Excessive debt

High ROE could also be a result of excessive debt. Companies sometimes use borrowed funds to boost their ROE — a practice known as leverage.

Leverage works when you can earn more from borrowed funds than it costs to borrow them. However, this strategy can be risky because if the returns on borrowed money don’t exceed the cost of the debt, there will be amplified losses.

Limits and disadvantages of Return on Equity (ROE)

• Debt impact — Companies with a lot of debt might have inflated ROE numbers.
• Short-term focus — The timeframe of an ROE is usually a year.
• One-time events — Special gains or losses, like selling a major asset or settling a lawsuit, can affect ROE.
• Company size — A small company might show a high ROE due to its scale, whereas a larger company with a lower ROE could still be more profitable overall.

How to overcome these limitations

• Don’t just look at the ROE. Other metrics you’ll need are the debt-to-equity ratio, operating margin, earnings per share, and price-to-earnings ratio.

• Check out the company’s cash flow statements and plans for expansion.

• Look into the company’s historical performance. Spikes or valleys in the ROE may mean the company has issues that have led to unplanned changes in business strategy.

The DuPont formula

Two firms can have the same ROE but achieve it in completely different ways. It’s important to analyze each part of the DuPont formula to really understand what’s going on.

Here’s what each component means:

• Net profit margin — Net income divided by sales. It shows the profit a company earns for every dollar of revenue. Improving this means making more profit from each sale.
• Asset turnover — Revenue divided by total assets, showing how well a company uses its assets to generate sales. A higher ratio means the company is getting more sales from its assets.
• Financial leverage — Total assets divided by shareholder equity, i.e. how much debt a company has relative to its equity. A higher leverage means the company is using more debt to boost its returns.

Other uses of Return on Equity

In addition to using the ROE to evaluate a company’s current performance, it can also help investors determine:

• Long-term sustainability.

• The success of a recent merger or other strategic change.

• A good time to buy back shares.