Return on Equity (ROE) is a ratio that helps investors understand the profitability of a company they are considering investing in. This ratio compares a company’s net income to its shareholder equity in order to show how effective a company is at using its investments to generate new revenue.
In other words, for every dollar that’s invested into the business, how much more revenue was generated?
How is ROE Calculated?
The formula for calculating Return on Equity is straight-forward. It simply takes net income and divides it by shareholder equity.
Return on Equity = Net Income / Shareholder Equity
Let’s break this down even further.
Net income, also known as net profit, is found on the income statement. It shows the total profit left over after cost of goods sold, operating expenses, and any other expenses have been taken into account. It is often called the “bottom line” for that reason—and because it can be found at the very bottom of the income statement.
Shareholder equity lives on the balance sheet. If your company were to liquidate all of its assets and pay off all liabilities, shareholder equity would be left. The balance sheet is set up to reflect the accounting equation (Assets = Liabilities + Shareholder Equity). To find shareholder equity, simply subtract liabilities from assets.
One important difference to note between the income statement and the balance sheet, where these two metrics live, is time. The income statement looks at the revenue and expenses that took place over a defined period of time. The balance sheet, on the other hand, only shows a snapshot of the company at a specific moment.
Your income statement might show the last fiscal year, for example. But when it comes to shareholder equity, which lives on the balance sheet, you’ll need to decide whether to pull that number from the start of the fiscal year, the end of it, or take an average of the two. In most cases, averaging the shareholder equity at the start of the year and the end of the year is encouraged. Whatever your company decides, however, make sure to keep it consistent from year to year.
Interpreting Return on Equity
So what is a healthy ROE, and what would be cause for concern to investors? The answer to that question varies based on the industry you’re in.
If you sell construction supplies, for example, an ROE around 20% is what you should aim for. But if you sell healthcare products, an ROE closer to 7% is the norm.
Knowing the average return on equity for your industry will help your investors see how you stack up. If you’re beating the average with a higher ROE, they may expect to see bigger returns on their investments.
Limitations of Return on Equity
Return on equity is one way of analyzing the health of a business, but it should not be the only metric consulted. Taken alone, ROE can present a distorted view of a business’ profitability in a few scenarios.
Consider a company with a very high ROE compared to their industry. They could, in fact, be outperforming the competition by a longshot. However, they could also just have very little equity to speak of. With high profits and low equity (the denominator in this equation), return on equity becomes distorted and doesn’t accurately show how that equity is being used to generate more revenue.
If a company has also taken on a large amount of debt, this will also cause shareholder equity to shrink and ROE to shoot up in response. In this case again, a high ROE is not necessarily a sign of business health, so much as a response to a business decision.
Businesses in the process of buying back shares will also show a higher-than-average ROE, as buying back shares also reduces shareholder equity overall.
There are many reasons why a company’s ROE may beat the average or fall short of it. For that reason, investors will also often look at some complementary metrics to help understand the full picture of your business.
Return on Equity vs. Return on Capital
Return on capital (ROC) takes return on equity one step further. In addition to looking at a company’s shareholder equity, it also takes debt into consideration.
The calculation for ROC is:
Return on Capital = Net Income / (Shareholder Equity + Debt)
This calculation allows investors to see if debt is behind an abnormally high ROE. If a company brings in $200,000 in revenue for example and has $1M in equity, the return on equity would be 20%.
If that same company also has $600,000 in debt, their return on capital would be 12.5%. Looking at these two metrics together helps investors get a better idea of the full picture of the business.
Return on Equity vs. Return on Assets
Return on Assets (ROA) adds another layer to understanding the health of a business. Total assets includes everything that the company possesses, whether or not they own them outright. This can include company vehicles, equipment, or simply cash. ROA, therefore, shows investors how a company is putting those resources they possess to use in order to drive profit.
The calculation looks like this:
Return on Assets = Net Income / Total Assets
Total assets is also found on the balance sheet. It’s the other half of the accounting equation (Assets = Liabilities + Equity). Remember: because it lives on the balance sheet, which does not show change over time, you’ll need to average assets over the period in question or remain consistent about using total asset numbers from the start or end of the period.
This calculation is often more helpful to internal team members than it is to shareholders, who are more concerned with seeing returns on the money they’ve invested. However, companies should keep a close eye on both ROE and ROC to ensure they remain appealing to investors.