Return on Equity Explained: Your Guide to Financial Health

ROE is represented as a percentage and can be calculated for any business, provided that both net earnings and owners’ equity are positive.

What high and low ROE mean

A company with a high net income and relatively low equity will have a high return on equity, which means it generates significant returns on its investments. Conversely, if a company has modest profits but a larger equity base, its ROE will be lower. This balance between profits and equity is at the heart of what ROE reveals about a company.

The formula for calculating return on equity (ROE)

To determine return on equity, divide the net earnings by the equity of shareholders and then multiply by 100 to convert it into a percentage. This figure shows the profit generated for each dollar of invested equity.

Here’s the basic formula:

Return on equity = net income / shareholders’ equity × 100

For a more accurate picture, especially if the equity changes during the year, it’s better to use the average shareholders’ equity. You’d calculate it like this:

Return on equity = net income / average shareholders’ equity × 100

Example of ROE calculation

Let’s walk through a simple ROE calculation with this example:

• Financial period: January 2023 - December 2023
• Net income: $75 000
• Total assets: $450 000
• Total liabilities: $120 000

Step 1: Calculate shareholders’ equity

First, find the company’s equity using: shareholders’ equity = total assets − total liabilities

So: shareholders’ equity = $450 000 − $120 000 = $330 000

Step 2: Calculate return on equity

Next, use the ROE formula: ROE = net income / shareholders’ equity

In this case: ROE = $75 000 / $330 000 ≈ 0.227

Step 3: Convert to percentage

To express ROE as a percentage: ROE = 0.227 × 100 ≈ 22.7%

This means the company earned about 22.7 cents for every dollar of equity invested, which is a solid return.

Calculating Return on Equity With Multiple Periods

Now, let’s look at a company with financials split into two 6-month periods:

Period 1 (January 2023 - June 2023):

• Net income: $10 000
• Total assets: $80 000
• Total liabilities: $40 000

Period 2 (July 2023 - December 2023):

• Net income: $15 000
• Total assets: $100 000
• Total liabilities: $50 000

Step 1: Calculate shareholders’ equity for each period

For Period 1: shareholders’ equity = $80 000 − $40 000 = $40 000

For Period 2: shareholders’ equity = $100 000 − $50 000 = $50 000

Step 2: Find the average shareholders’ equity

Average equity over the two periods: average shareholders’ equity = ($40 000 + $50 000) / 2 = $45 000

Step 3: Calculate total net income

Add the net income from both periods: total net income = $10 000 + $15 000 = $25 000

Step 4: Calculate return on equity

Using the average equity: ROE = total net income / average shareholders’ equity × 100, ROE = $25 000 / $45 000 × 100 ≈ 55.6%

Over these two periods, the company generated approximately 55.6 cents for every dollar of equity, which is a high return.

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 company A has an ROE of 15% and keeps 70% of its earnings, its growth rate will be: 15% × 70% = 10.5%

If company B also has an ROE of 15% but keeps 90% of its earnings, its growth rate will be: 15% × 90% = 13.5%

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)

Return on equity provides a valuable measure, but it has its drawbacks that you should keep in mind:

• Debt impact — Companies with a lot of debt might have inflated ROE numbers. When a company takes on debt, its equity decreases, which can make the ROE seem higher than it really is since profits are divided among fewer equity dollars.
• Short-term focus — Return on equity measures profitability over a specific period, usually a year, which might encourage focusing on short-term gains rather than long-term growth.
• One-time events — Special gains or losses, like selling a major asset or settling a lawsuit, can affect ROE. These are not part of the company’s everyday operations and can distort the true picture of its performance.
• Size of company — 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

To get a fuller view of a company’s financial health, make sure to consider return on equity alongside other metrics like the debt-to-equity ratio, operating margin, earnings per share, and price-to-earnings ratio.

You can also look at the company’s cash flow statements to make sure that its high ROE is supported by strong cash flow from operations. Also, consider the company’s growth prospects by looking at its plans for expansion, new product lines, or market penetration.

Another thing to look at is historical performance. A consistently high ROE indicates robust management and operational efficiency. Meanwhile, fluctuations could signal underlying issues or unplanned changes in business strategy.

The DuPont formula

To dive even deeper into what return on equity really tells us, you can use DuPont analysis. This method breaks down ROE into three key ratios to help you understand how a company achieves its ROE, its strengths, and areas for improvement.

The DuPont formula is expressed as:

ROE = net profit margin × asset turnover × financial leverage

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.

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 undersand what’s going on.

What is an ideal return on equity (ROE)?

Different sectors have different benchmarks, so determining whether an ROE is good or not depends on the industry the company is in. For example, utilities usually have high assets and debt but lower profits, so a normal ROE for them might be around 10% or less, while tech or retail companies, which typically have smaller balance sheets compared to their earnings, might show an ROE of 18% or higher.

A simple rule is to aim for an ROE that is at or just above the average for the company’s industry. For instance, if a company has an ROE of 18% while its industry average is 15%, that points to the company having close to an ideal ROE.

Return on equity expectations also vary a lot from one industry to another. Generally, anything below 10% is seen as low, and an ROE near or above the long-term average for the S&P 500 (around 21.71% as of mid-2024) is considered strong.

Comparative ROE

When using a company’s ROE, it’s useful to see how it measures up against its industry and specific segments within that sector.

Take Bank of America as an example. In the second quarter of 2023, its ROE was 11.2%. Compared to the average ROE for the entire banking industry, which was 13.57%, Bank of America was slightly behind.

However, it’s also important to consider the type of banks included in these averages. The FDIC data includes all types of banks: like commercial, consumer, and community. For commercial banks specifically, which include Bank of America, the average ROE was 10.92%. So, Bank of America’s ROE was actually better than the average within its own subset of the industry.

Other uses of return on equity

ROE’s applications extend beyond just evaluating current performance. It can also offer valuable insights into various strategic and financial aspects of a company.

Assessing long-term sustainability

ROE helps gauge how well a company is likely to perform over the long term. If a company consistently posts a high ROE, it often means the business model is solid and can support ongoing success.

For example, if a company has had an ROE of 20% for several years, it suggests the company might continue to show similar numbers in the future and show strong potential for sustained growth.

Analyzing strategic changes

When a company makes big moves, like merging with another company or launching a new product, ROE helps measure how well those decisions are working out.

For instance, if a company’s ROE jumps from 12% to 18% after acquiring a smaller competitor, the acquisition might be boosting profitability and aligning with the company’s strategic goals. Conversely, if the ROE drops, this might signal that the strategic change isn’t having the desired effect.

Guiding stock buybacks

Finally, high ROE can influence a company’s decision to buy back its own shares. Companies often repurchase shares to return value to shareholders when they’re generating strong returns.

For example, if a company has an ROE of 25%, it might use its excess cash to buy back shares, believing that the stock is undervalued. This move can boost the stock price and increase earnings per share, which will benefit existing shareholders.

Summary

Return on equity helps investors understand how effectively a company transforms its equity into profits. Generally, an ROE of 15-20% is seen as strong and indicates solid management. However, the ROE isn’t a perfect metric — it doesn’t cover everything, like how a company handles debt or market conditions. Plus, excessive ROE could be a result of high financial leverage (i.e. a lot of debt) or other factors that increase risk.

So, while a good ROE is generally a positive sign, it’s best to look at other financial metrics and consider the broader market as well.