The return on equity ratio can be described as a financial ratio that helps measure a company’s proficiency to generate profits from its shareholders’ investments. This profitability helps to gauge a company’s effectiveness when it comes to using equity funding to run its daily operations.
By figuring out the ROE of a company, individuals can find out how much post-tax income is left in its reserve. Subsequently, one can compare net income to the total shareholder equity as recorded on its balance sheet.
ROE ratio also helps you understand how a company compares to other firms in the same industry and evaluate the company’s financial performance and asset valuation.
How is ROE Ratio Calculated?
The ROE ratio is calculated by dividing the net income of the company by total shareholder equity and is expressed as a percentage. The ratio can be calculated accurately if both the net income and equity are positive in value.
Return on equity ratio formula is expressed as –
Return on equity = Net income / Average shareholder’s equity.
Here, net income is computed before dividends are allocated to the common shareholders. Further, it is calculated after dividends are paid out to preferred shareholders, and interest is paid to lenders.
For instance, in a financial year, the earnings of ABC and Co. were Rs. 21,906,000, while the average shareholder equity was Rs.209,154,000. Therefore by using this ROE ratio formula, the value would be –
Return on Equity= Rs. 21,906,000/ Rs.209,154,000 = 10.47%.
By factoring in the ROE of a company, investors can pick a profitable investment option. To elaborate, a company with an ROE which is equivalent to its market competitors or more is considered profitable.
What are the Benefits of ROE Ratio?
The list below highlights the different purposes for which ROE ratio is used and thus underlining its benefits –
Estimating the growth rate
Regardless of the few challenges, the return on equity ratio is considered to be an effective way of assessing the growth rate of a company’s stock and dividend.
Typically, a company’s ROE is multiplied by its retention ratio to calculate such growth. Here the retention ratio is the proportion of the company’s net income that has been retained or reinvested for enhancing its growth prospect.
Gauging sustainability of growth
Return on equity ratio analysis further helps to assess a company’s sustainability in terms of its growth. With the help of this financial ratio, investors can identify the stocks that are more exposed to market risks and financial instabilities.
For instance, a company stock that is growing at a relatively slow rate when pitted against its sustainable rate could be seen as undervalued or financially struggling in the market. Similarly, a company that is surpassing its sustainable growth ability also projects a problematic or erratic image in the market as well.
Investors can further use the ROE ratio to estimate the dividend growth of a particular company. Such an estimate can be made accurately by multiplying the company’s ROE with its payout ratio.
Regardless, it must be noted that a company that shows a dividend growth that is above or below the sustainable growth rate may indicate operational risks.
Identification of problems with ROE Ratio
Excessive debts, erratic returns, and negative income are some of the issues that can be scrutinized with the help of the ROE ratio. Even though an extremely high ROE ratio may indicate an underlying risk or problem, it is not always the case.
For example, in a situation where the company’s net income is relatively high when compared to its equity, the high ROE is seen as an indication of its strong performance. However, the equity that is smaller than net income tends to hint at underlying risks.
What are the Limitations of ROE?
Though ROE is considered to be one of the best financial metrics to gauge a company’s financial efficiency, it has its share of limitations. To begin with, the returns on equity may not always be positive. A subjective ROE may indicate several underlying issues; for instance, exceeding debts and irregular profits, among others.
Similarly, a negative return on equity ratio arising due to negative shareholder’s equity or net loss does not prove useful for analysing a company’s proficiency. Further, it cannot be used to compare the proficiency of those companies which have a favourable ROE.
Other than these, the ROE ratio tends to overstate a company’s economic value, which depends on several economic factors.
The following highlights a few of such elements and how ROE impacts it –
- Depreciation: Usually, a high rate of depreciation leads to a lower net income and in turn, lowers the ROE significantly.
- Project lifespan: Projects with longer shelf-life are more likely to show an overstated ROE.
- Investment’s growth rate: Mostly, rapidly growing companies require substantial equity; this tends to lower its return on equity ratio.
- Capitalization policy: In case, the books show low market capitalisation levels, the ROE will be significantly low.
- Gap between investment outlay and associated recoupment: The degree of ROE overstatement is also dependent on the time it takes a company to recoup its profits.
Return on Equity Ratio Analysis
Here’s an overview of return on equity ratio interpretation –
- Helps measure the efficiency with which a company uses shareholders’ investment to generate more revenue.
- This profitability ratio is a projection of investors’ investment in the company.
- Mostly, a robust ROE indicates that a company is utilising the fund generated through shareholders’ investment efficiently.
ROE ratio vs. Return on Invested Capital
Investors should make it a point to learn about the differences between ROE ratio and return on invested capital to eliminate the risk of confusing them. A fair idea about the differences would further help to understand the concept of ROE more effectively.
To begin with, the ROE ratio helps investors to compute the profit that a company is likely to generate through shareholder’s equity. On the other hand, return on invested capital helps them figure out the money a company makes through various sources of capital.
ROE helps investors to check a company’s proficiency when it comes to utilising shareholders equity. Contrarily, return on invested capital (ROIC) helps determine the effectiveness of a company to use available capital to generate more income.
A company’s growth prospect plays a significant role in judging its profitability. Hence, investors must devise ways to check the same before investing in them. Since the return on equity ratio along with other financial ratios is considered to be useful for gauging the same, investors should utilise them accordingly.
