Return on equity (ROE)
| Return on equity (ROE) |
|---|
| See also |
Return on Equity (ROE) is a financial ratio used to measure the profitability of a business in relation to the shareholders’ equity. It is calculated by dividing the company’s net income by the shareholders’ equity. A higher ROE indicates that a company is more profitable and generates more income from the equity invested by its shareholders.
ROE can be used to compare the performance of different companies or the same company over different periods of time. It also helps investors assess the risk associated with investing in a company as it provides an indication of how efficiently the company is using its equity to generate profit. Generally, a higher ROE indicates a more efficient use of equity and a better return on the shareholder’s investment. A lower ROE may indicate that the company is not managing its equity efficiently.
Example of Return on equity (ROE)
The following example illustrates the calculation of ROE for a company with a net income of $500,000 and shareholders’ equity of $2,000,000.
- ROE = Net Income / Shareholders’ Equity
- ROE = $500,000 / $2,000,000
- ROE = 0.25
Therefore, the company’s return on equity is 25%.
Overall, ROE provides a good indication of how well a company is using its equity to generate income. It can be used to compare the performance of different companies or the same company over different periods of time. Additionally, it can help investors assess the risk associated with investing in a company.
Formula of Return on equity (ROE)
Advantages of ROE:
- ROE provides an indication of how efficiently a company is using its equity to generate profit.
- It helps investors assess the risk associated with investing in a company.
- It can be used to compare the performance of different companies or the same company over different periods of time.
Disadvantages of ROE:
- ROE does not take into account the leverage of a company, which can lead to an inaccurate assessment of the company’s performance.
- ROE does not take into account the value of other assets such as inventory or real estate.
When to use Return on equity (ROE)
- Return on equity is particularly useful when comparing the performance of different companies in the same industry, as it helps investors identify the most efficient and profitable companies.
- It can also be used to compare the same company over different periods of time, in order to identify trends in the company’s profitability.
- ROE can also be used to assess the risk associated with investing in a company, as a higher ROE indicates a more efficient use of equity and a better return on the shareholder’s investment.
Types of Return on equity (ROE)
- Return on Equity (ROE) can be divided into two main categories: Absolute ROE and Sustainable ROE. Absolute ROE is calculated by taking the company’s current net income and dividing it by its equity. This provides an indication of the company’s performance in the current period. Sustainable ROE takes into account the company’s reinvestment of profits in the business, as well as its debt levels, to provide a more accurate indication of the true return on equity for the company.
- Return on Equity (ROE) can also be divided into four main components: Margin, Turnover, Leverage and Tax. Margin is calculated by taking the company’s net income and dividing it by its sales. Turnover is calculated by taking the company’s sales and dividing it by its assets. Leverage is calculated by taking the company’s assets and dividing it by its equity. Tax is calculated by taking the company’s net income and subtracting its tax liability. Each of these components can be used to provide an indication of the company’s performance and can be used to compare the performance of different companies.
Return on Equity (ROE) is a useful and important financial ratio that can be used to evaluate the profitability of a business in relation to the shareholders’ equity. It provides investors with an indication of how efficiently the company is using its equity to generate profits, and can be used to compare the performance of different companies or the same company over different periods of time. ROE can be divided into two main categories, Absolute and Sustainable, as well as four main components, Margin, Turnover, Leverage and Tax. Understanding ROE can provide investors with a better understanding of the risk associated with investing in a particular company.
Steps of Return on equity (ROE)
- The first step in calculating ROE is to determine the company’s net income. This is the total amount of money the company has earned after expenses, taxes, and other deductions are taken into account.
- The second step is to determine the company’s shareholders’ equity. This is the total amount of money that shareholders have invested in the company, including retained earnings and common stock.
- The third step is to divide the company’s net income by its shareholders’ equity to calculate the ROE.
Advantages of Return on equity (ROE)
- ROE provides a measure of a company’s profitability in relation to the equity invested by its shareholders. This helps investors assess the risk associated with investing in a company and make decisions about whether to invest or not.
- ROE also helps investors compare the performance of different companies or the same company over different periods of time. This is useful for evaluating the performance of a company and making investment decisions.
- ROE can also be used to compare the performance of different industries or sectors. This helps investors identify potential opportunities and make investment decisions.
Disadvantages of Return on equity (ROE)
- ROE can be affected by a company’s leverage, meaning that it may not be an accurate measure of a company’s profitability if the company has a high debt to equity ratio.
- ROE does not take into account a company’s cash flow, which can be an important factor when making investment decisions.
- ROE does not take into account the cost of capital, which can also be an important factor when making investment decisions.
ROE is not a perfect measure of a company’s performance as there are some limitations. These include:
- It does not take into account the company’s debt levels, which can affect the return on equity.
- It is calculated using accounting numbers which may not be accurate or may not reflect the true performance of the business.
- It may be affected by one-off events such as divestments or acquisitions, which could lead to a higher or lower ROE.
- It may be affected by changes in tax laws which could lead to a higher or lower ROE.
There are other approaches related to Return on equity (ROE) that can be used to analyze a company’s performance. These include:
- Return on Assets (ROA): ROA is a financial ratio that measures the profitability of a company in relation to its total assets. It is calculated by dividing the company’s net income by its total assets. A higher ROA indicates that a company is more efficient in generating income from its assets.
- Price to Book Ratio (P/B): P/B is a financial ratio that measures the market value of a company’s stock in relation to the book value of its equity. It is calculated by dividing the company’s market capitalization by its book value. A higher P/B ratio indicates that the company’s stock is trading at a higher price than its book value.
- Price to Earnings Ratio (P/E): P/E is a financial ratio that measures the market value of a company’s stock in relation to its earnings. It is calculated by dividing the company’s market capitalization by its net income. A higher P/E ratio indicates that the company’s stock is trading at a higher price than its earnings.
These other approaches related to Return on Equity (ROE) provide investors with additional insights into a company’s performance. They can be used in combination with ROE to help investors make more informed decisions about investing in a company.
Suggested literature
- Damodaran, A. (2007). Return on capital (roc), return on invested capital (roic) and return on equity (roe): Measurement and implications. Return on Invested Capital (ROIC) and Return on Equity (ROE): Measurement and Implications (July 2007).
- Ichsani, S., & Suhardi, A. R. (2015). The effect of return on equity (roe) and return on investment (roi) on trading volume. Procedia-Social and Behavioral Sciences, 211, 896-902.
- Heikal, M., Khaddafi, M., & Ummah, A. (2014). Influence analysis of return on assets (roa), return on equity (roe), net profit margin (npm), debt to equity ratio (der), and current ratio (cr), against corporate profit growth in automotive in Indonesia Stock Exchange. International Journal of Academic Research in Business and Social Sciences, 4(12), 101.
