Return on Equity (ROE) - What is it, formula, Limitations (2024)

FAQs

What are the limitations of ROE? ›

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.

The return on equity ratio can also be skewed by share buybacks. When management repurchases its shares from the marketplace, this reduces the number of outstanding shares. Thus, ROE increases as the denominator shrinks. Another weakness is that some ROE ratios may exclude intangible assets from shareholders' equity.

If the equity has become a small value, the income for some period might exceed it, and so the ROE would be over 100%. Operating margin is not closely related to ROE. Although operating income is related to net income, to calculate the margin you divide by sales, which is completely unrelated to shareholder's equity.

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.

Because ROE is so easy to manipulate, and because executives potentially have such a strong interest in artificially boosting it, investors can't know whether that ROE number is reliable or just a result of financial wizardry.

Disadvantages of the accounting rate of return

Unlike other methods of investment appraisal, the ARR is based on profits rather than cashflow. It is affected by subjective, non-cash items such as the rate of depreciation you use to calculate profits. The ARR also fails to take into account the timing of profits.

A high ROE might not always be positive. An outsize ROE can be indicative of a number of issues—such as inconsistent profits or excessive debt. ROE that widely changes from one period to the next may also be an indicator of inconsistent use of accounting methods.

ROE is ratio of (Profits earned)/(Equity). So manipulating profitability or equity component is how you change ROE. Using more debt instead of putting in equity by promoters. Debt financing is cheaper than equity and also faster.

Some major, profitable companies have recently had negative shareholders' equity, including well-known restaurant chains: McDonald's, Starbucks, and Papa John's. The primary driver in these cases may have been issuing massive debt and refranchising or selling corporate-owned stores to franchisees.

While average ratios, as well as those considered “good” and “bad”, can vary substantially from sector to sector, a return on equity ratio of 15% to 20% is usually considered good. At 5%, the ratio would be considered low.

What does ROE tell you? ›

ROE is a useful metric for evaluating investment returns of a company within a particular industry. A higher ROE signals that a company efficiently uses its shareholder's equity to generate income. Low ROE means that the company earns relatively little compared to its shareholder's equity.

What is ROE used for? ROE is used when comparing the financial performance of companies within the same industry. It is a measure of the ability of management to generate income from the equity available to it. A return of between 15-20% is considered good.

If ROE is too high, it indicates risk which can cause many problems. This can lead to inconsistent profits due to an extremely low denominator, which gives you a misleading ROE. Excess debt can also result in ROE, which means that there is low equity. It can also show a negative net income.

The return on equity (ROE) ratio tells you how much profit a business earned in comparison to the book value of its owners' equity. This ratio is especially useful for privately owned businesses, which have no easy way of determining the market value of owners' equity.

The RoE can be more than 100 if the income is greater than the equity.

The RoE can be more than 100 if the income is greater than the equity.

Leverage: ROE can be influenced by a company's capital structure and leverage. Companies with higher levels of debt may have higher ROE due to financial leverage, but this also increases the risk.

An industry's average ROE can change over time depending on external factors such as competition. On a company basis, a negative ROE may be caused by one-time factors such as restructurings that depress net income and produce net losses.

Using Return on Equity to Identify Problems

Sometimes an extremely high ROE is a good thing if net income is extremely large compared to equity because a company's performance is so strong. However, an extremely high ROE is often due to a small equity account compared to net income, which indicates risk.