When you invest in a company by buying shares of their stock, you are purchasing an ownership stake in that company. The only reason for an investor to buy a stock is with an expectation that they will profit from their investment. In other words, investors expect their investment to yield a positive return.
Some companies can be given limited resources and find a way to build a growing business that generates a generous profit for themselves and for those that invest in them. Other companies can have a nearly unlimited amount of resources yet can’t seem to generate a profit. As an investor, it’s pretty obvious which type of company you’d rather invest in, but figuring out which companies will fall into which category, and how much of a return can be expected from an investment, is not that obvious.
One of the fundamental measurements of how well a company is generating profit for its shareholders is Return on Equity (ROE), sometimes referred to as Return on Net Worth (RONW). This article will review what Return on Equity measures, how it is calculated and what is considered a good ROE. We will also review some variations of the calculation for ROE and factors that can affect the calculation of ROE. Finally, we’ll discuss why ROE should not be the only measurement that investors use to evaluate a company.
What is return on equity (ROE)?
Return on equity is a measurement of how efficient a company is in using its assets from their shareholders to create earnings. Specifically, ROE is a measure of how well a company is able to generate profits from the investments that shareholders have made in their company. Said in another way, how much profit does the company generate from each dollar of equity provided by stockholders?
So if a company has an ROE of .15, it means that every dollar of stockholders’ equity is generating fifteen cents of net income. Expressed as a percentage this would be an ROE of 15%.
How do you calculate return on equity (ROE)?
Return on equity is calculated by using the following formula:
Return on Equity = Net Income (per fiscal year)/Shareholders’ Equity
So if a company generates $1,000,000 of income in a fiscal year and in that same period they issued 100,000 shares of stock valued at $10 per share, their ROE would be:
1,000,000/ (100,000 x 10) = 1
This means that every dollar of shareholder equity generated about $1. This comes out to be a 100% return on their investment. This would be considered extremely high, but our example is extremely simplistic.
Before we go on, it’s important to define a couple of terms.
Net income is determined by subtracting total expenses from total revenues. This is found on a company’s income statement.
Shareholders’ equity is calculated by subtracting total liabilities from total assets. This is found on a company’s balance sheet.
In this way, you can view ROE as a key of sorts that helps decode what a company’s income statement is saying as well as what their balance sheet is saying. So in our example, if the company had lower net income, but had the same amount of shareholder equity, their ROE would be lower. Conversely, if their net income had stayed the same, but their shareholder equity was lower, their ROE would increase.
What is considered a good ROE?
In general, an ROE between 15% and 20% indicates that this company is in growth mode. However, there is no simple answer because the best way to interpret ROE is to compare it to a company’s peer groups. For example, if you are looking at a company that is in an emerging technology field, you may see a low or even a negative ROE as these companies may not yet be generating a profit, or they may be plowing their profit into R&D or other areas in anticipation of future revenue.
What you should be looking for is an ROE that is at par (in-line with) or just above the average of similar companies. So in that example, if the start-up company you're looking for has an ROE that is comparable to its competitors (if they have any), then you have to do a little further digging to become comfortable with what that number is telling you.
If an ROE is too high relative to that average it may mean that the company is borrowing money in terms of loans as a form of financing or they could be buying back their own stock. Either of these scenarios would reduce shareholder equity which would inflate their ROE. What this can point to is that the company may be taking on too much risk, which (depending on your risk tolerance) may not be something you’re comfortable with.
If an ROE is too low relative to that average it may mean that the company is underperforming. This could be a case where they are run very conservatively and not using all of the assets available to them (such as taking on reasonable debt) in an effort to grow. This can make the ROE low because their income is low compared to how much equity they have. What this means for investors is that they should not expect stock prices to rise quickly.
At this point, it's important to keep in mind that return on equity is a number created by investors for investors. It is not a calculation that a company is going to provide in their financial statements. While they will provide the raw data that will allow investors to calculate ROE for themselves, they will not calculate it for them.
Variations on the formula for Return on Equity
Because ROE is something that’s left for an investor to figure out for themselves, many savvy investors have created different ways to tweak the formula to get a more meaningful result.
- Return on Common Equity (ROCE)is a variation of ROE that only takes into account the equity held by common shareholders (excludes preferred shares). The formula for ROCE is:
ROCE = (Net income - preferred dividends)/common equity
- Using average shareholder equity– in some cases, investors may want to take the average of shareholders’ equity at the beginning of a period and at the end. This is simply done by adding the two numbers together and dividing by two.
- Calculate a beginning and ending ROE to monitor a change in profitability over a period of time– just like an investor can look at price movement over time, they can look use the shareholders’ equity from the beginning of a period to use in calculating the beginning ROE and the end-of-period shareholders’ equity to determine the ending ROE.
- Averaging ROE over the course of five to 10 years – ROE is typically a one-year measurement. So, to give yourself a better idea of a company’s growth from a historical perspective, it may be helpful to calculate ROE over a long period of time to see trends.
What factors can affect Return on Equity?
As we mentioned above, ROE is an imperfect measure. Companies can, sometimes as a matter of course, use different accounting techniques that will affect ROE. Anything that inflates book value (i.e. shareholder’s equity) will bring ROE down. Anything that reduces shareholders’ equity will bring ROE up. So what are some ways that can happen?
Items that could increase a company’s book value of shareholders’ equity
Items that could decrease a company’s book value of shareholders’ equity
Having a high cash balance (this can lower a company’s return on assets and increases their cost of capital.)
Stock buybacks, because this means fewer shares are available.
Reporting excessive goodwill (if any)
Write-downs – these are not necessarily bad things, but it's important to see what guidance the company provides as a reason for the write-off.
Profit after a long period of losses – this is known as cumulative profits and they can boost equity just as cumulative losses can reduce equity. Like write-downs, they are not necessarily bad but require further explanation.
Research and development (R&D) costs – although this topic goes beyond the scope of this article, basically companies are required to list R&D costs as an expense. For companies that are in an emerging industry, they may have high R&D costs that may affect profitability.
What are the limitations of return on equity?
Return on equity only measures the profit (return) that is attributed to shareholders. It does not take into account the total capital invested in the business, which is calculated by adding its equity plus its debt. Why does this matter? Simply put, debt can be good and debt can be bad.
In some cases, a company can be generating a healthy income, but not providing much value to shareholders because they must use that income to service debt through, for example, interest charges.
However, if a company can get a higher rate of return than what they are paying to service the debt, then taking higher amounts of debt will increase shareholder profits (i.e. shareholders can profit for themselves from the borrowed money the company is using).
The bottom line on ROE
Return on equity measures how efficiently a firm uses shareholder money to generate profits and grow the business. Unlike other ratios, for example, Return on Investment (ROI), Return on Equity (ROE) is a ratio that gives an investor an idea of how much money they should expect from their investment in the company. It is not based on any investment the company may make in assets.
While there is no fixed answer to what a good return on equity is, it is generally assumed that a high return on equity is better than a low return on equity. This is because a higher ROE suggests that the company is using shareholders’ money efficiently to generate profits.
However, ROE only provides a snapshot of a company’s potential profitability. Every industry has different expectations for profit and that’s why many investors need to look at a variety of competing companies within an industry to see what an average ROE is supposed to look like. If investors try to compare two companies in different industries, ROE will become a far less significant measurement.
As investors become more familiar with the variables behind ROE, they can choose to adjust the formula as needed to get the data that they feel is most important. For example, they can choose to calculate ROE at both the beginning of a period and the end of that period to see if the ROE has changed, and to what extent. This can give them a clue as to if and how fast a company is growing and its ability to maintain that trend.