How to calculate ROE (Return on Equity) to determine the profitability of the company
If you are considering investing in a company, you will need to have a reliable way to measure the return on that company's capital. After all, what is the point of investing if the returns do not prove fruitful? Return on equity, or ROE for short, does exactly that. It measures the profitability of a company, and it is one of the most important metrics in business and investing.
But how is ROE calculated? And most importantly, once you learn the result, how do you interpret it? A negative ROE doesn't always indicate risk capital, and sometimes a positive ROE can be a mirror for larks.
Find out in our article how ROE is calculated and how to compare it with the company's other balance sheet ratios.
What is return on equity (ROE)?
Return on equity (ROE) is a way for investors to measure a company's financial performance. More specifically, it is the company's profitability in relation to its equity. ROE measures corporate performance by comparing after-tax income to total shareholders' equity. ROE appears in the list of balance sheet indicators that stockholders use to compare it with managerial performance.
ROE, Return on equity, is also sometimes called return on net assets because shareholders' equity is equal to a company's net assets, after debt.
Because ROE measures the percentage of investor capital that has been converted to income, it is a good way to determine how efficiently your company is managing your invested money. The rate of satisfaction will depend on benchmarks such as industry, size and comparison with other similar companies. In general, a company with a relatively higher ROE has a greater chance of generating income using stakeholders' invested capital.
How is return on equity (ROE) calculated?
The basic formula for calculating ROE is:
ROE= ( Net Operating Income / Equity(equity) ) x 100
Net operating income is the final profit-before common stock dividends are paid-reported on a company's income statement. Free cash flow (FCF) is another form of profitability and can be used instead of net income.
Shareholders' equity is the assets minus liabilities on a company's balance sheet and is the book value that remains to shareholders if a company settles its liabilities with reported assets.
Note that ROE should not be confused with return on total assets (ROTA). The latter is also an indicator of profitability. However, 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 in different periods to compare its change in value over time. By comparing the change in ROE growth rate from year to year or quarter to quarter, for example, investors can track changes in managerial performance.
Practical example of ROE calculation
Let's try to calculate ROE using an example. First, let's imagine that company X has a net income of 10 million in one year. At the beginning of the year, the average shareholders' equity was 25 million euros. You were able to find these numbers by consulting Company X's income statement and balance sheet.
Using these numbers, ROE would be calculated in this way:
ROE = Net Income/Average Equity
ROE = (10,000,000 / 25,000,000) = 0.4
ROE = 0.4 x 100% = 40%
Following the ROE formula, we calculated that company X's return on equity during that year was 40%.
Correctly interpreting the ROE result
Measuring a company's ROE performance against that of its industry is just one of the possible comparisons.
For example, in the fourth quarter of 2020, Bank of America Corporation had an ROE of 8.4 percent. According to the Federal Deposit Insurance Corporation, the average ROE of the banking industry in the same period was 6.88 percent. In other words, Bank of America outperformed industry expectations.
However, the FDIC's calculations included all types of banks, including commercial, consumer and community banks. Since Bank of America is, in part, a commercial lender, one has to go and check the corresponding value in the commercial bank sector. The ROE for commercial banks was 5.62 percent in the fourth quarter of 2020. We can, therefore, conclude that its ROE still turns out to be higher than that of other commercial banks.
Consequently, it is not only important to compare a company's ROE with the industry average, but also with similar companies within that industry.
When evaluating companies, some investors also use other indicators, such as Return on capital employed (ROCE) and ROI, Return on investment, and ROA, Return on assets. Investors often use ROCE instead of the standard ROE to judge a company's longevity. In general, both are more useful indicators for capital-intensive businesses, such as utilities or manufacturing.
Correctly interpreting the ROE result
ROE will always tell a different story depending on the financial data, such as whether equity changes due to share repurchases or income is small or negative due to a one-time loss. Understanding the components that caused a negative ROE is critical. Let's look at all the possible scenarios.
What does a negative ROE mean?
There may be circumstances in which a company's net worth is negative. This usually occurs when a company has suffered losses for a period of time and has had to borrow money to continue to stay in business. In this case, liabilities will be greater than assets.
Thus, even if in the current year, the company has generated substantial profits and is therefore profitable from a financial point of view, the result will be a negative roe.
Is too high an ROE positive?
You might think that stocks with a high ROE constitute great value, but this is not always the case. As an investor, you need to be careful and make sure that the company you are interested in can offer a solid ROE, but also grow at a sustainable rate. If you find a company with a very high ROE, you should do a thorough analysis of its finances.
You will need to look for possible problems such as inconsistency in profits, excess debt, and negative net income.
Profit inconsistency
A high ROE can sometimes signal inconsistent profit, so be very careful. The ROE formula itself is explanatory of this situation. Let us say that company Z has reported losses for several years in a row. These losses are recorded in the equity section of the balance sheet as retained losses. Since this is a negative number, it reduces the amount of equity.
Now, let's say Company Z suddenly has a sales spike and performs very well in the current year. When ROE is calculated for that year, it will result in high net income, which will be divided by a very small denominator, net worth. Because of the simple math, this will result in a deceptively high ROE.
Excess debt
Another common problem that arises with a high ROE is excess debt. Remember, equity equals net assets after debt. If a company has borrowed aggressively to stay afloat, again you have an example where the denominator becomes very small. This results in a high ROE that could lead you astray.
Negative net income
Last but not least, negative net income can be another trap for investors. It was mentioned earlier that ROE should not be calculated if net income or net worth is negative. Both negative net income and negative net worth can create a falsely high ROE. If a company has to report a net loss, rather than net income, then ROE should not be calculated.
Do you still have questions about ROE calculation? If you need clarification, please write to us in the comments section.
Article translated from Italian