The Return on Equity (ROE) is a financial ratio that measures profitability for shareholders. It is calculated by dividing its net income by shareholders’ equity. Shareholders’ equity, which represents a company’s assets minus its debt, is considered net assets.
Investors also use ROE to analyse the performance and growth of a company, as it is key indicator to identify a company’s profitability and efficiency in generating profits.
In this article, we will learn about ROE, the ROE formula, how to find the ROE of a company and more.
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What is ROE?
The ROE or return on equity indicates the returns shareholders generate for their shareholding in the company. In other words, it indicates the returns shareholders are earning for every rupee they have invested in the company.
The ROE indicates the profitability and efficiency of the company. It is calculated by dividing a company’s net income by its total shareholders’ equity.
Naturally, the higher the ROE of a company, the more the shareholders earn. But it is important to note that typical ROE levels may differ from industry to industry.
Return on equity: Highlights
- The ROE measures a company’s returns against its shareholders’ investment and is typically used by fundamental investors to make investment decisions.
- ROE is calculated by dividing the net income by shareholders’ equity.
- A higher ROE indicates that the company management is working efficiently to generate profits for company investors. A low ROE can be a red flag.
- The ROE differs from ROCE. The former measures profitability against shareholders’ investment, while the latter measures profitability against total capital employed.
What does ROE indicate?
The ROE can help investors make investment decisions. Investors prefer to invest in companies with higher ROE as it shows that the company is efficiently utilising shareholders’ money to generate profit for a given period. A higher ROE than the industry average is considered a positive sign. The reverse also holds true.
It is important to note that the ROE varies from industry to industry. For a valid comparison, companies from the same industry must be pitched against one another. However, investment decisions should not be made solely on the basis of the ROE. For a holistic analysis, it is important to use other fundamental metrics as well.
How to calculate the ROE?
The ROE can be calculated using a simple ROE formula, as shown below:
ROE = Net income / Shareholders’ equity
The net income can be determined from the income statement, whereas shareholders’ equity can be found in the balance sheet. Typically, net income and shareholders’ equity are calculated as follows:
Net income/earnings = Total revenue – (Taxes + Operating expenses + Depreciation +Other expenses)
Shareholders’ equity = Paid up capital +Retained earnings – Treasury stock
ROE vs ROI
ROI stands for ‘return on investment.’ Let’s see how it differs from ROE.
| Basis of difference | ROE | ROI |
| Definition | Return on equity is the return earned on the equity share capital employed. | Return on investment is the amount earned on the initial cost or the initial amount invested. |
| Measure | ROE shows the profitability of the company, keeping the base as the amount of equity capital. | ROI is used to measure how efficiently a project or investment is being undertaken and how much profit it is generating. |
| Debt | Debt is not included while computing the amount of return on equity. | The amount of debt is included while measuring the ROI. |
| Formula | ROE = Net profit income / Shareholder’s equity | ROI = Net income / Cost of investment *1000 |
Both these metrics thus differ significantly in terms of what they indicate. ROI helps you understand how valuable an investment has been based on its profits. On the other hand, ROE reflects the returns generated by the shareholders’ equity.
Let us see if ROE is what you should look at while measuring stock market returns.
Is ROE the right measure for stock market returns?
The ROE is one of the most-used metrics when assessing the performance of a stock. As the ROE shows how much is earned on equity, shareholders can assess how the company uses their invested funds to generate profits.
Essentially, the higher the ROE, the higher the profits earned on the equity. It is a better metric for the shareholders as it shows that the company is working efficiently, employing its resources well, and earning stable/ high profits. All of this reflects well in the share price and the dividend distributed to the shareholders.
However, analysing the ROE alone can be misleading. There may be many reasons why the ROE might have increased. Moreover, a very high ROE might also show that funds are lying idle with the company. Thus, to get a better idea of the stock market returns, it is important that you do not rely on just ROE but also analyse other measures alongside it.
ROE vs ROCE
Investors often confuse ROE with Return on Capital Employed (ROCE). However, both are starkly different concepts.
| Difference on the basis of | ROE | ROCE |
| Definition | ROE ratio measures the returns investors generate against their shareholding or investment. | ROCE measures the profit a business can generate against its total employed capital. |
| Depicts | ROE depicts returns against profits made by a company. | ROCE depicts how well the capital is employed to generate returns. |
| Formula | ROE = (Net profits/ Shareholders’ equity) | ROCE = EBIT/Total capital employed |
| Uses | The formula employs net profits or PAT (profits after tax). | The formula considers EBIT (earnings before interest and taxes) or operating profits. |
| Considers | ROE only considers shareholders’ funds. | ROCE considers debt and other obligations besides shareholders’ funds. |
| Scope | The scope of ROE is limited as only one factor (equity) is considered. | ROCE offers a wider scope as it considers both debt and equity. |
| Applicability | ROE, more or less, can be used to study all companies and their returns. | ROCE works better for capital-intensive industries. |
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Conclusion
The ROE is one of the important ratios used by investors to understand a company’s profitability. This ratio measures the profitability of a company against shareholders’ investment. The ROE, along with other metrics, should be used by investors to make better investment decisions. Do your research, and analyse your risk appetite, investment horizon, and investment goals before taking any investment decisions.
