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What’s it: Return on equity (ROE) is a profitability ratio to measure how high the return is on the invested equity capital. We get it by dividing net income by total equity, expressed as a percentage. Also known as return on owners’ equity and return on shareholders’ equity.
A high ROE is preferred because it indicates a profitable operation. This is because companies use equity capital efficiently to generate more profits.
However, we should further examine why ROE is higher, whether due to increased net income or decreased equity (increased leverage).
Why is the return on equity important?
Return on equity (ROE) is important to measure the company’s efficiency in generating profits using its equity capital. Stock investors use it and compare it to industry averages to show how well the company is making a profit.
Unlike return on invested capital (ROIC), ROE only measures the return to shareholders. In contrast, ROIC measures return to shareholders and creditors by comparing net income to invested capital (equity plus debt).
When companies are efficient, they generate revenue at the lowest possible cost. Eventually, it translates to higher profits.
Calculating retention ratio
ROE is the input to calculate the sustainable growth rate, which shows how high dividend growth can be maintained by the company over time. And it is an important metric in valuing a company’s stock.
We calculate the sustainable growth rate by multiplying the ROE by the retention rate. Then, to calculate the retention rate, we divide retained earnings by net income, showing the percentage of net profit the company holds back to fund long-term growth.
- Sustainable growth rate = Retention rate × ROE
- Sustainable growth rate = (Retained earnings / Net profit) × (Net profit / Average total equity)
How to calculate return on equity?
Calculating ROE requires only arithmetic operations, so it’s easy. We divide net profit by the average total equity to obtain it, expressed as a percentage.
- ROE = Net profit / Average total equity
Net profit, or net income, is the money left over from revenue after paying all expenses. It’s on the income statement, on the bottom row.
Meanwhile, we calculate the average total equity by adding the equity at the beginning of the period to the equity at the end of the period and dividing the result by 2. The numbers are on the balance sheet.
Then, to calculate the total equity, we can also apply the accounting equation. We subtract total assets by total liabilities.
For example, suppose a company makes a net profit of $2 million. On the balance sheet, the company reports total assets of $10 million and total liabilities of $4 million.
First, we calculate total equity by subtracting total assets by total liabilities, equal to $6 million = $10 million – $4 million. Then, we divide net income by total equity to get the ROE, which is 33.3% = $2 million/$6 million.
Return on common equity as an alternative
Common stock investors focus more on the return on common equity (ROCE) ratio than ROE. This is because it shows what a net return they received.
As we know, company equity can come from preferred stock or common stock. Preferred stockholders have prior rights over common stockholders to the dividends distributed.
Because it uses net income as the numerator, ROE does not differentiate how much profit is distributed to preferred and common stockholders. Instead, ROCE accommodates this problem and focuses on the profits entitled to be claimed by common stockholders.
To calculate ROCE, we subtract net income by dividends distributed to preferred stockholders. After getting it, we divide the result by the total common equity capital. Here is the formula:
- Return on common equity (ROCE) = (Net profit – Preferred dividend) / Average common equity
How to interpret the return on equity?
In general, higher ROE is better, indicating the company is generating high returns efficiently using invested equity capital. Thus, shareholders expect higher dividends distributed to them.
Conversely, a low ratio is less desirable because the company is less efficient in investing its equity to generate profits. For example, it occurs because it generates revenue at a high cost. Thus, less profit is earned.
Then, to examine why a company’s ROE is high, we can start analysis using DuPont decomposition. It provides important guidance by breaking down ROE into several key financial ratios. Briefly, it explains ROE can go up for the following reasons:
- Higher net profit margins indicate the company is generating revenue at lower costs.
- Higher asset turnover indicates the company is successfully utilizing its assets to generate more revenue.
- Higher leverage means the company relies more on debt than equity to generate profits, making total equity relatively small.
Variations between companies
What is the ideal ROE depends on what is normal in each industry. Companies in different industries can have different percentages. Therefore, comparing ROE between companies in the same industry is important to evaluate whether they are better than their competitors.
For instance, companies in the semiconductor industry have a higher ratio (about 21%) than rubber or tire companies (about 6%). Likewise, the normal ROE in the online retail sector is around 20%, higher than wholesale and food retail (15%).
Leverage effect
Variations in ROE may result from differences in funding strategies. When a company relies more on debt than equity to grow assets and profits, it can result in higher ROE – as described in the DuPont decomposition. ”
When companies borrow more to generate higher profits, liabilities will increase rapidly. Since not all net income is retained as internal capital, the increase in net income will be higher than the increase in total equity.
A more obvious case is when a company takes on debt to buy back its shares. As a result, total equity falls. Thus, ROE will increase because the smaller numerator assumes net income does not change.
However, taking on too much debt to grow assets and profits indicates risk. The company will have to pay the high-interest expense in the future. If a company is unable to make adequate revenue or operate at a more efficient scale, it could weigh on net income.
