Return on equity (ROE) is a measure of a company’s financial performance. It can help a company work out if they are using their resources well and can aid investors in working out if they are getting a good bang for their buck. It is simple to read and easy to use for comparisons with other companies, but should not be solely relied upon by investors.
How ROE works
ROE is worked out by dividing a company’s annual net income, minus any dividend paid to preference shares, by its average shareholders’ equity. Shareholder equity can be obtained by subtracting a company’s total liabilities from its total assets.
For example, if net income stands at $1m and shareholder equity is $12m, you can divide the former by the latter and then multiply the result by 100 to gain a percentage value. This lets you work out that the company’s ROE is 8.3%.
Once you have the ROE figure, you can make a judgement about the company’s performance. By and large, an ROE below 10% is not seen as satisfactory. However, it is worth comparing companies to their industry peers for greater insight. Companies in crowded sectors where a lot of assets are needed will have lower ROE than those with less direct competitors.
ROE alone should not be steering your investment decisions. The metric must be considered alongside other measures of financial health, such as ROA.
Types of ROE
As demonstrated above, you can calculate ROE by dividing net income by shareholder equity. However, you can use an alternative method. This different method includes many extra steps and is called the DuPont decomposition, having been created by the DuPont company almost a century ago.
The first version of this variant allows you to work out ROE by multiplying a company’s net profit margin, asset turnover and equity multiplier.
The second DuPont ROE variant is significantly more complex. The formula for this method uses operating margin, turnover, borrowing costs, equity and tax rate . Your first step is to multiply operating margin by turnover, before subtracting borrowing costs. Then, you must multiply the resultant figure by equity and then multiply this by one minus the company’s tax rate.
Though this formula will obviously be more challenging for you to calculate, it can offer a deeper insight into the figures that are driving any change in ROA.
Advantages of ROE
An important advantage to note can be seen in the difference between ROE and ROA, or return on assets. The latter metric measures a company’s productivity relative to its assets.
While this is useful when analysing how well a company is utilising its own assets, ROE offers investors insight into how successfully their investment is being used to make money.
Disadvantages of ROE
ROE can be misleading depending on what stage of its development a company is at. For example, capital requirements can be high for newer companies so they might struggle to record a high ROE.
ROE can be misleading in cases where a company is achieving inconsistent profits or has excessive debt. Additionally, when a company reports negative net income its the calculation will lead to a negative ROE. However, this does not necessarily mean it would be unwise to invest.
You might find that the company made a loss because it was spending money on improvements. For example, startups will generally have negative ROEs for a period after launch because they are investing so heavily in expansion.