Return on Equity – ROE

What Is Return on Equity (ROE)?

Return on equity (ROE) is a measure of financial performance calculated by dividing net income by shareholders' equity. Because shareholders' equity is equal to a company’s assets minus its debt, ROE is considered the return on net assets. ROE is considered a measure of how effectively management is using a company’s assets to create profits.

Understanding Return on Equity

ROE is expressed as a percentage and can be calculated for any company if net income and equity are both positive numbers. Net income is calculated before dividends paid to common shareholders and after dividends to preferred shareholders and interest to lenders.

$\begin{aligned} &\text{Return on Equity} = \dfrac{\text{Net Income}}{\text{Average Shareholders' Equity}}\\ \end{aligned}$​Return on Equity=Average Shareholders’ EquityNet Income​​

Net income is the amount of income, net of expense, and taxes that a company generates for a given period. Average shareholders' equity is calculated by adding equity at the beginning of the period. The beginning and end of the period should coincide with the period during which the net income is earned.

Net income over the last full fiscal year, or trailing 12 months, is found on the income statement—a sum of financial activity over that period. Shareholders' equity comes from the balance sheet—a running balance of a company’s entire history of changes in assets and liabilities.

It is considered best practice to calculate ROE based on average equity over a period because of the mismatch between the income statement and the balance sheet.

What Does ROE Tell You?

Whether ROE is deemed good or bad will depend on what is normal among a stock’s peers. For example, utilities have many assets and debt on the balance sheet compared to a relatively small amount of net income. A normal ROE in the utility sector could be 10% or less. A technology or retail firm with smaller balance sheet accounts relative to net income may have normal ROE levels of 18% or more.

A good rule of thumb is to target an ROE that is equal to or just above the average for the peer group. For example, assume a company, TechCo, has maintained a steady ROE of 18% over the last few years compared to the average of its peers, which was 15%. An investor could conclude that TechCo’s management is above average at using the company’s assets to create profits. Relatively high or low ROE ratios will vary significantly from one industry group or sector to another. When used to evaluate one company to another similar company, the comparison will be more meaningful. A common shortcut for investors is to consider a return on equity near the long-term average of the S&P 500 (14%) as an acceptable ratio and anything less than 10% as poor.

Using ROE to Estimate Growth Rates

Sustainable growth rates and dividend growth rates can be estimated using ROE, assuming that the ratio is roughly in line or just above its peer group average. Although there may be some challenges, ROE can be a good starting place for developing future estimates of a stock’s growth rate and the growth rate of its dividends. These two calculations are functions of each other and can be used to make an easier comparison between similar companies.

To estimate a company’s future growth rate, multiply the ROE by the company’s retention ratio. The retention ratio is the percentage of net income that is retained or reinvested by the company to fund future growth.

ROE and a Sustainable Growth Rate

Assume that there are two companies with an identical ROE and net income, but different retention ratios. Company A has an ROE of 15% and returns 30% of its net income to shareholders in a dividend, which means company A retains 70% of its net income. Business B also has an ROE of 15% but returns only 10% of its net income to shareholders for a retention ratio of 90%.

For company A, the growth rate is 10.5%, or ROE times the retention ratio, which is 15% times 70%. Business B's growth rate is 13.5%, or 15% times 90%.

This analysis is referred to as the sustainable growth rate model. Investors can use this model to make estimates about the future and to identify stocks that may be risky because they are running ahead of their sustainable growth ability. A stock that is growing slower than its sustainable rate could be undervalued, or the market may be discounting risky signs from the company. In either case, a growth rate that is far above or below the sustainable rate warrants additional investigation.

This comparison seems to make business B more attractive than company A, but it ignores the advantages of a higher dividend rate that may be favored by some investors. We can modify the calculation to estimate the stock’s dividend growth rate, which may be more important to income investors.

Estimating the Dividend Growth Rate

Continuing with our example from above, the dividend growth rate can be estimated by multiplying ROE by the payout ratio. The payout ratio is the percentage of net income that is returned to common shareholders through dividends. This formula gives us a sustainable dividend growth rate, which favors company A.

The company A dividend growth rate is 4.5%, or ROE times the payout ratio, which is 15% times 30%. Business B's dividend growth rate is 1.5%, or 15% times 10%. A stock that is growing its dividend far above or below the sustainable dividend growth rate may indicate risks that should be investigated.

Using ROE to Identify Problems

It is reasonable to wonder why an average or slightly above average ROE is good rather than an ROE that is double, triple, or even higher the average of their peer group. Aren’t stocks with a very high ROE a better value?

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.

Inconsistent Profits

The first potential issue with a high ROE could be inconsistent profits. Imagine a company, LossCo, that has been unprofitable for several years. Each year’s losses are recorded on the balance sheet in the equity portion as a “retained loss.” The losses are a negative value and reduce shareholder equity. Assume that LossCo has had a windfall in the most recent year and has returned to profitability. The denominator in the ROE calculation is now very small after many years of losses, which makes its ROE misleadingly high.

Excess Debt

A second issue that could cause a high ROE is excess debt. If a company has been borrowing aggressively, it can increase ROE because equity is equal to assets minus debt. The more debt a company has, the lower equity can fall. A common scenario is when a company borrows large amounts of debt to buy back its own stock. This can inflate earnings per share (EPS), but it does not affect actual performance or growth rates.

Negative Net Income

Finally, negative net income and negative shareholder equity can create an artificially high ROE. However, if a company has a net loss or negative shareholders’ equity, ROE should not be calculated.

If shareholders’ equity is negative, the most common issue is excessive debt or inconsistent profitability. However, there are exceptions to that rule for companies that are profitable and have been using cash flow to buy back their own shares. For many companies, this is an alternative to paying dividends, and it can eventually reduce equity (buybacks are subtracted from equity) enough to turn the calculation negative.

In all cases, negative or extremely high ROE levels should be considered a warning sign worth investigating. In rare cases, a negative ROE ratio could be due to a cash flow supported share buyback program and excellent management, but this is the less likely outcome. In any case, a company with a negative ROE cannot be evaluated against other stocks with positive ROE ratios.

Limitations of ROE

A high ROE might not always be positive. An outsized ROE can be indicative of a number of issues—such as inconsistent profits or excessive debt. Also, a negative ROE due to the company having a net loss or negative shareholders’ equity cannot be used to analyze the company, nor can it be used to compare against companies with a positive ROE.

ROE vs. Return on Invested Capital

While return on equity looks at how much profit a company can generate relative to shareholders’ equity, return on invested capital (ROIC) takes that calculation a couple of steps further.

The purpose of ROIC is to figure out the amount of money after dividends a company makes based on all its sources of capital, which includes shareholders equity and debt. ROE looks at how well a company uses shareholder equity while ROIC is meant to determine how well a company uses all its available capital to make money.

Example of ROE in Use

For example, imagine a company with an annual income of $1,800,000 and average shareholders' equity of $12,000,000. This company’s ROE would be as follows:

$ROE=\left(\frac{\$1,800,000}{\$12,000,000}\right )=15\%$ROE=($12,000,000$1,800,000​)=15%

Consider Apple Inc. (AAPL)—for the fiscal year ending Sept. 29, 2018, the company generated US$59.5 billion in net income. At the end of the fiscal year, its shareholders’ equity was $107.1 billion versus $134 billion at the beginning. Apple’s return on equity, therefore, is 49.4%, or $59.5 billion / (($107.1 billion + $134 billion) / 2).

Compared to its peers, Apple has a very strong ROE.

• Amazon.com Inc. (AMZN) had a return on equity of 27% in 2018,
• Microsoft Corp. (MSFT) 23% in Q3 2018, and
• Google—now know as Alphabet Inc. (GOOGL) 12% for 2018 Q3.