Return on equity (ROE) 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, it measures the profitability of a corporation in relation to stockholders’ equity. The higher the ROE, the more efficient a company's management is at generating income and growth from its equity financing.
ROE is often used to compare a company to its competitors and the 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.
- Return on equity (ROE) 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's management is at generating 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.
Return On Equity (ROE)
Formula and Calculation of Return on Equity (ROE)
The basic formula for calculating ROE is:
ROE=Shareholder EquityNet Income
The net income is the bottom-line profit—before common-stock dividends are paid—reported on a firm’s income statement. Free cash flow (FCF) is another form of profitability and can be used instead of net income.
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.
ROE can also be calculated at different periods to compare its change in value over time. By comparing the change in ROE's growth rate from year to year or quarter to quarter, for example, investors can track changes in management's performance.
Putting It All Together
The ROE of the entire stock market as measured by the S&P 500 was 12% in the fourth quarter of 2020. A 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 might show the stocks of the railroad sector performing very well compared to the market as a whole, with an ROE value of 19.66%, while the general utilities and retail sales sectors had ROEs of 5.77% and 18.11%, respectively. This could indicate that railroad companies have been a steady growth industry and have provided excellent returns to investors.
The next step involves looking at individual companies to compare their ROEs with the market as a whole and with companies within their industry. For instance, at the end of FY 2019, Procter & Gamble (PG) reported a net income of $4 billion and total shareholders' equity of $47.6 billion. Thus, PG's ROE as of FY 2019 was:
- $4 billion ÷ $47.6 billion = 8.4%
P&G's ROE was below the average ROE for the consumer goods sector of 14.41% at that time. In other words, for every dollar of shareholders' equity, P&G generated 8.4 cents in profit.
Not All ROEs Are the Same
Measuring a company's ROE performance against that of its sector is only one comparison.
For example, in the fourth quarter of 2020, Bank of America Corporation (BAC) had an ROE of 8.4%. According to the Federal Deposit Insurance Corporation (FDIC), the average ROE for the banking industry during the same period was 6.88%. In other words, Bank of America outperformed the industry.
In addition, the FDIC calculations deal with all banks, including commercial, consumer, and community banks. The ROE for commercial banks was 5.62% in the fourth quarter of 2020. Since Bank of America is, in part, a commercial lender, its ROE was above that of other commercial banks.
In short, it's not only important to compare the ROE of a company to the industry 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.
When Shareholder Equity Is Negative
There can be circumstances 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.
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.
If one were to calculate return on equity in this scenario when profits are positive, they would arrive at a negative ROE; however, this number 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 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.
The Bottom Line
Return on equity (ROE) 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. It is critical to utilize a variety of financial metrics to get a full understanding of a company's financial health before investing.