Return on Equity is a financial metric used to ascertain how effective management is in using underlying assets to create profits and value. Investors rely on the ratio to measure how efficiently management uses the money contributed. Simply put, it is a measure of a company’s profitability relative to stockholders’ equity.
Return on Equity Calculation
Return on Equity is calculated by dividing a company’s total net income with shareholder equity.
Net income is a company’s bottom-line profit before deduction of dividends.
Shareholders’ equity, on the other hand, refers to total assets minus liabilities on the balance sheet.
A higher ROE ratio signals how efficient a company’s management is in using equity to generate profits and growth.
Analysts rely on ROE to ascertain how efficient a company is compared to its competitors as well as to the overall market. The metric is especially beneficial in comparing companies in the same industry affected by the same factors. A company with a higher ROE relative to the industry average is considered an ideal investment pick given its ability to use underlying assets to generate value.
A return on equity number that’s better than industry average highlights management’s ability to create profits.
Return on Equity Importance
Return on Equity is not just a measure of profitability. It’s also a measure of efficiency, key to long-term value generation. A company with a rising ROE suggests management can generate more profit as the value of underlying assets increases. A higher Return On Equity also indicates how efficient management is in deploying shareholder capital in high-growth projects that generate long-term value.
It’s important to note that as shareholders’ equity in a company increases while net profit remains constant or increases, Return on Equity will continue to increase. Companies can boost Return on Equity by carrying out buybacks that essentially reduce shareholders’ equity. High debt levels also boost companies’ ROE, as they translate to less shareholder equity.
Return on Equity can also be used to estimate a company’s growth and dividend growth rates. Financial analysts compute the company’s growth rates by multiplying the underlying ROE by the retention rate. The retention rate is the amount of income that a company retains to fund future growth projects.
Likewise, the rate at which a dividend is likely to grow is calculated by multiplying ROE by the payout ratio. The amount of net income that a company pays out as dividends, represented as a percentage of net income, is the payout ratio.
Identifying Problems with ROE
Return on Equity can be used to identify problems in a company. While a high ROE is most of the time deemed a good thing, at times it is not. Extremely high ROE can be risky though, since it signals small equity account compared to net income, a leading indicator of risk.
Inconsistent profits can at times lead to high ROE, which can also deceive investors. For instance, a company with a trend of losses might have a sudden windfall and return profits that lead to a high ROE. A high ROE can also occur as a result of excess debt, which significantly reduces shareholders’ equity. The higher the debt with income remaining constant, the higher the ROE.