Table of contents
What is the return on equity?Return on equity formulaHow to calculate return on equity?What is a good return on equity?Return on equity vs. return on capital employedHow to use ROE interpretation for buying or selling options?FAQsWe made this return on equity calculator to help you calculate ROE. It is a very popular and important indicator in business that shows a company's efficiency.
In this short article, you will find out what is the return on equity in general and what a good return on equity is. Additionally, we will quickly explain the difference between the return on equity and the return on capital. To learn more, go straight to the paragraph titled return on equity vs. return on capital.
Because you're interested in ROE, you might also want to check out other business calculators, such as the ROA calculator, which measures the profitability of a company in generating profit from its assets.
What is the return on equity?
First, let us answer the question: what is the return on equity? ROE (return on equity) is a ratio of profitability, which shows how much profit the company has managed to make from its equity. In other words, this is the company's ability to generate profit with the shareholders' money. ROE is also known as "return on net worth" (RONW).
Return on equity formula
Now that you already know what return on equity is, you may ask: how to calculate ROE? Let's find an answer!
The return on equity formula is based on two variables – you probably have already guessed which ones. We need:
- Net profit; and
- Equity.
The next step is to calculate the relation between them by dividing the first one by the second and, in the end, multiplying the result by 100% – don't forget about this step, as ROE is always expressed as a percentage. Knowing this, you probably won't have any problems with a derivation of the return on equity formula:
ROE = (net profit / equity) × 100%
How to calculate return on equity?
Now, let's have a look at how it works in practice. Imagine a company with the following parameters:
- Net profit: $34,500; and
- Equity: $456,000.
What will the value of ROE be in this case?
ROE = 34,500 / 456,000 × 100% = 7.57%
What is a good return on equity?
While we already know what ROE is, there's a next question to pose. What is a good return on equity?
The value of ROE should be as high as possible. The higher the ROE of a company, the firmer and more beneficial its situation on the market.
The best value of ROE is roughly several dozen percent, but such a level is difficult to reach and then maintain. A good return on equity is much lower. Economists say that it is about 10-15% – such value is supposed to be likely to keep.
Return on equity vs. return on capital employed
The problem for many people is to notice the differences between indicators that seem to be similar. That's why we have made a quick comparison return on equity vs. return on capital as they are close to each other.
ROCE (return on capital employed) is a ratio that indicates the profitability of the investment in which the whole employed capital of a company is engaged. As opposed to ROE, ROCE considers not only equity but also liabilities. Thanks to this fact, it is more useful when we want to analyze a company with long-term debt. If you want to calculate ROCE, use the return on capital employed calculator.
On the other hand, it is also key to analyze how the company is financially funded. For such an endeavor, we can use the debt-to-capital ratio, which relates the interest-bearing debt to the shareholder's equity (see debt to capital ratio calculator). Contrary to the ROE, a higher debt-to-capital ratio might indicate too much debt in the company's capital structure.
Finally, about the stock market, you will notice that a high ROE will increase the stock price. In such a trend, it is pretty easy to make gains. However, you can even protect your returns by only investing in a stock that's above its 7-day moving average price.
How to use ROE interpretation for buying or selling options?
A high ROE through several years indicates the strength of the business. If no side bump is foreseeable, it may be highly profitable to buy call options (see call option calculator).
If ROE has been contracting during the last few years, we can expect a stock price decline. Consequently, we might protect ourselves with a put option or any other bearish options spread — visit our options spread calculator to learn more.
How do I calculate ROE?
You can calculate the ROE in three steps:
Determine the net profit.
Calculate the equity (i.e., the company's value).
Apply the ROE formula:
ROE (%) = (net profit / equity) × 100
Is a 2% ROE good?
A 2% ROE is generally considered low and may indicate that the company is not effectively using shareholders' equity to generate profits.
What is strong ROE ratio?
A strong ROE ratio varies by industry, but generally, an ROE above 15% to 20% is considered strong, indicating effective use of shareholders' equity to generate profits.
What is the ROE if net profit is $1,000 and equity is $20,000?
The ROE will be 5%. You can calculate it by dividing the net profit by the equity and multiplying the result by 100:
ROE = (1000/20000) × 100 = 5%
