A company's financial performance is a broad indicator of how well a company uses its assets, makes money, and conducts its business. Put simply, a company's financial performance can tell you how healthy it is and whether it is financially sound. There are several key financial metrics that can help you determine whether a business is performing well or isn't living up to industry standards. One of the figures that many analysts and investors use is the return on equity (ROE). In this article, we look at what ROE is, how to calculate it, and how it's used when analyzing companies.
Key Takeaways
- Return on equity is a financial ratio that shows how well a company is managing the capital that shareholders have invested in it.
- To calculate ROE, one would divide net income by shareholder equity.
- The higher the ROE, the more efficient a company'smanagementis atgenerating income and growth from its equity financing.
- When utilizing ROE to compare companies, it is important to compare companies within the same industry, as with all financial ratios.
What Is Return on Equity (ROE)?
Return on equity is a ratio that provides investors with insight into how efficiently a company (or more specifically, its management team) is handling the money that shareholders have contributed to it. In other words, ROE measures the profitability of a corporation in relation to stockholders’ equity. The higher the ROE, the more efficient a company'smanagementis at generating income and growth from its equity financing.
ROE is often used to compare a companyto its competitors andthe overall market. The formula is especially beneficial when comparing firms of the same industry since it tends to give accurate indications of which companies are operating with greater financial efficiency and for the evaluation of nearly any company with primarily tangible rather than intangible assets.
Formula and Calculation of Return on Equity (ROE)
While the calculation can be accomplished using Excel, the basic formula for calculating ROE is:
ROE=ShareholderEquityNetIncome
Where:
- Net incomeis the bottom-line profit—before common-stock dividends are paid, which is reported on a firm’s income statement.
- Shareholder equity is assets minus liabilities on a firm’s balance sheet and is the accounting value that's left for shareholders should a company settle its liabilities with its reported assets.
Note that ROE is not to be confused with the return on total assets (ROTA). While it is also a profitability metric, ROTA is calculated by taking a company's earnings before interest and taxes (EBIT) and dividing it by the company's total assets.
ROEcan also be calculated at different periods to compare its change in value overtime.By comparing the change in ROE's growth rate from year to year or quarter to quarter, for example,investors can trackchanges inmanagement's performance.
Free cash flow (FCF) is another form of profitability and can be used insteadof net income.
Analyzing Return on Equity (ROE)
The ROE of the entire stock market as measured by the was 16.38% in the third quarter of 2023, as reported by CSI Market. The first, critical component of deciding how to invest involves comparing certain industrial sectors to the overall market.
For example, a look at ROE figures categorized by industry during that same period might show the stocks of the railroad sector performing very well compared to the market as a whole, with an ROE value of 21.63%, while the utilities and life insurance industries had ROEs of 13.52% and 5.98%, respectively. This could indicate that railroad companieshave been a steady growth industry and have provided excellent returns to investors.
The next step involves looking at individual companies to compare theirROEswith the market as a whole and with companies within their industry. For instance, Procter & Gamble (PG) reported a net income of $3.42billion and total shareholders' equity of $45.42billion during Q3-2023. Thus, PG's ROE as of that period was:
$3.42 billion ÷ $45.42billion = 7.53%
P&G's ROE was belowthe average ROE for the consumer goods sectorof 24.64% at that time.In other words,for every dollar of shareholders' equity, P&G generated 7.53 cents in profit.
Comparing Return on Equity (ROE)
Measuring a company's ROE performance against that of its sector is only one way to make a comparison.
For example, in the second quarter of 2023, Bank of America Corporation (BAC) hadan ROE of 11.2%. According to the Federal Deposit Insurance Corporation (FDIC), the average ROEfor the banking industry during the same period was 13.57%. In other words, Bank of America underperformed the industry.
In addition, the FDIC calculations deal with all banks, including commercial, consumer, and community banks. TheROE for commercial banks was10.96%in the second quarter of 2023. Since Bank of America is, in part,a commercial lender, its ROE wasabove that of other commercial banks.
In short, it's not only important to compare the ROE of a company to theindustry average but also to similar companies within that industry.
In evaluating companies, some investors use other measurements too, such as return on capital employed (ROCE) and return on operating capital (ROOC). Investors often use ROCE instead of the standard ROE when judging the longevity of a company. Generally speaking, both are more useful indicators for capital-intensive businesses, such as utilities or manufacturing.
ROE will always tell a different story depending on the financials, such as if equity changes because of share buybacks or income is small or negative due to a one-time write-off. Understanding the components is critical.
When Shareholder Equity Is Negative
There can be circ*mstances when a company's equity is negative. This usually occurs when a company has incurred losses for a period of time and has had to borrow money to continue staying in business. In this case, liabilities will be greater than assets.
If one were to calculate return on equity in this scenario when profits are positive, they would arrive at a negative ROE. This number, though, would not be telling the entire story. It could indicate that a company is actually not making any profits, running at a loss because if a company was operating at a loss and had positive shareholder equity, the ROE would also be negative.
In a situation when the ROE is negative because of negative shareholder equity, the higher the negative ROE, the better. This is so because it would mean profits are that much higher, indicating possible long-term financial viability for the company.
What Does Return on Equity Tell You?
Return on equity tells you how efficiently a company can generate profits. Generally the higher the ROE the better, but it is best to look at companies within the same industry or sector with one another in order to make comparisons.
What Is the Average ROE for U.S. Stocks?
The S&P 500 had an average ROE of 19.94% in the third quarter of 2023. Of course, different industry groups will have ROEs that are typically higher or lower than this average.
How Do You Calculate ROE Using DuPont Analysis?
ROE can be alternatively calculated using DuPont analysis. There are two such versions, one decomposing ROE with three steps and the second with five:
- ROE = Net Profit Margin x Asset Turnover x Equity Multiplier
- ROE = (Earnings Before Tax ÷ Sales) x (Sales ÷ Assets) x (Assets ÷ Equity) x (1 - Tax Rate)
The Bottom Line
Return on equity is an important financial metric that investors can use to determine how efficient management is at utilizing equity financing provided by shareholders. It compares the net income to the equity of the firm. The higher the number, the better, but it is always important to measure apples to apples, meaning companies that operate in the same industry, as each industry has different characteristics that will alter their profits and use of financing.
As with all investment analysis, ROE is just one metric highlighting only a portion of a firm's financials. Another way to look at company profitability is by using the return on average equity (ROAE). Still, these calculations will only give a portion of the total picture. It is critical to utilize a variety of financial metrics to get a full understanding of a company's financial health before investing.
