Return on Equity

Return on equity (ROE) is a useful metric for calculating a company's financial performance. It is calculated by dividing net income by shareholders' equity. It is a profitability ratio that depicts how well the company makes profits from equity capital. Let's explore in-depth the meaning of Return on Equity, ROE formula, calculation, interpretation and more here.

What is Return on Equity

ROE full form stands for Return on equity. ROE refers to a measurement of a corporation’s or an enterprise’s performance in a given period. To determine ROE, one needs to assess the net income of the brand and divide it by the shareholders’ equity. 

Before proceeding to learn more about return on equity, an individual should assess the two factors responsible for this figure – the net income and the stockholders’ equity. A net income for a business refers to its profitability after deduction of associated costs, such as taxes, interests, depreciation, expenses, amortization and more. 

On the other hand, shareholders’ equity literally refers to the remaining profits after all debts related to the business, for that period, have been paid or cleared. Simply put, calculating such an equity figure is as simple as deducting its liabilities from its assets for the said company.

Return on equity is a percentage figure that can help business owners gauge the performance of their firms. It can also provide an insight into a firm’s management of equities and investments to produce returns. Thus, prospective investors often consider the ROE of an enterprise before putting their money in it.

Difference Between Rate of Return and Return on Equity

Individuals often face confusion when it comes to ROE and rate of return. However, these two terms are significantly different from one another. 

The following table should help illustrate the basic differences between the two–

Formula to Calculate ROE

Now that you know ROE meaning, let's understand the ROE Formula-

One must remember that shareholders’ equity, considered in this calculation, refers to an average equity for a business’s stockholders’ since each individual shareholder may possess different equities.

How to Calculate ROE?

Calculation of ROE is feasible only if both the net income and the stockholders’ equity are positive for a business. Basically, if Rs. 5 from a shareholders’ stock generates Re. 1 as net income, the ROE for that company would be 20%. 

Those looking for a better return on equity example should take a look at this table below –

Therefore, 

• Return on equity ratio = 3,50,000 / 5,80,000 = 3:5
• Return on equity = 0.60 x 100 = 60%

What is an Ideal Return on Equity (ROE) ?

One cannot declare a particular range of ROE as a good return on equity. For some industries, an ROE of more than 25% is desirable, while for others, a figure over 15% may be considered exceptional. However, a lower ROE does not always indicate impending catastrophe for a business. In some cases, the ROE may decline in a particular year due to a host of reasons. 

For instance, the company may have purchased some necessary machinery recently after receiving a sum of fresh investment. In such an event, the return on equity for the said firm would decline, but only temporarily. Investors would, therefore, need to determine the long-term ROE to gauge the true position and performance of the company.

Here are some cases where a high ROE may be indicative of a negative impact on the business –

• Declining Equity Investment

If the equity investment in a business decreases, the returns will increase, but such an event does not indicate more profitability.

For instance, consider Company X achieved a net income of Rs. 0.60 crore in 2018. At that point, its shareholders’ equity accounted for Rs. 4 Crores. Therefore, the ROE would be 0.60/4 multiplied by 100, which is equal to 15%.

Now, consider that the same company experienced a similar net income of Rs. 0.60 Crore the next year. However, this time, the equity from shareholders fell to just Rs. 2 Crores. Thus, this led to the ROE doubling to 30%. However, lack of shareholders’ equity indicates that the company is suffering.  

• Increased Debt Can Appreciate ROE

Similarly, a corporation that is under excessive debt also experiences a sudden rise in ROE but, again, this is not ideal.

Additionally, a new firm may not even have a positive return on equity until it manages to break even. However, such a state does not necessarily indicate mismanagement of the firm. 

Thus, judging a company’s potential solely by return on equity may not always be the best move. Experienced investors generally rely on several forms of data and not just the ROE percentage before investing. 

How to Interpret ROE?

Whether it is the return on equity of a company or ROE in the stock market, interpreting the same can be tricky. A steady increase in ROE indicates that stockholders are increasingly placing more trust in that particular firm. 

One should understand that the only way for a brand to build earnings quicker than its ROE appreciation is to borrow funds from the market. Even so, such a boost is temporary since the additional debt undercuts the company’s net income further.

Thus, fund managers often use the ROE of a company to determine its growth potential since the return on equity limits the capability of growth and expansion.

Limitations Of ROE - Why is ROE considered an Imperfect Scale?

Most experts agree that return on equity is a faulty scale to measure a company’s success or failures for the following reasons –

1. ROE for a firm receives a boost every time the shareholder equity pool declines. Thus, if investment in the company subsides, it can positively affect the return on equity.
   
   
2. A high ROE fails to differentiate between companies with impressive management and those drowning in debt. This is because increased debt leads to a reduction in the equity figures for the firm. With decreased equities, the ROE increases. Therefore, although the company has high debts, an outsider looking at the ROE would fail to perceive the same.
   
   
3. Another major issue with return on equity is that it only takes into account the tangible assets of a firm. Therefore, if a company holds patents, trademarks, brand names and other intangible property, the same is left out when calculating its ROE. This results in inaccurate projections of a company’s asset management.
   
   
4. Executives of the company can easily manipulate the ROE. Doing so is not only possible but also beneficial in many cases where growth of this metric is linked to higher compensation for high-level executives in the firm. Often, an impressive return on equity is leveraged for personal gain, completely disregarding the negative impact such a move creates on the business as a whole.

An individual lacking additional knowledge about the company may form a faulty impression regarding the brand from its ROE.