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What Is Return on Equity (ROE)?
Let me explain return on equity (ROE) to you directly: it's a financial performance ratio that shows how a company uses shareholders' equity to generate net income. You calculate it by dividing net income by shareholders' equity, and since shareholders' equity equals assets minus debt, ROE essentially reveals the return on a company's net assets.
ROE serves as a gauge of a corporation's profitability and the efficiency with which it generates those profits. If the ROE is higher, it means the company's management is more efficient at turning equity financing into income and growth.
Key Takeaways
- To calculate ROE, divide a company's net income by its shareholders' equity.
- ROE measures a corporation's profitability and profit generation efficiency.
- A higher ROE shows better conversion of equity financing into profits.
- ROE varies by sector, so compare it within the same industry for the most accurate insights.
- A quick way to assess ROE is by comparing it to the current long-term average of the S&P 500.
How Return on Equity (ROE) Works
ROE is expressed as a percentage, and you can calculate it for any company. Net income here is figured before dividends to common shareholders but after those to preferred shareholders and interest to lenders.
Whether you consider an ROE good or bad depends on what's normal for that stock's peers. For instance, utilities often have lots of assets and debt with relatively low net income, so a normal ROE there might be 10% or less. In contrast, tech or retail firms might see normal ROEs of 18% or more due to smaller balance sheet accounts relative to net income.
Here's a rule of thumb I use: aim for an ROE that's equal to or just above the average for the company's sector. Take a company like TechCo with a steady 18% ROE over years, against a peer average of 15%—that suggests TechCo's management is above average in using assets to create profits.
ROE ratios can vary a lot between industry groups or sectors. A common investor shortcut is to view anything under 10% as poor and something near the S&P 500's long-term average as acceptable.
Calculating Return on Equity (ROE)
It's best to calculate ROE using average equity over a period to account for mismatches between the income statement and balance sheet. The basic equation is ROE equals net income divided by shareholders' equity.
Net income is net revenue minus all expenses, including interest and taxes—it's the most conservative profitability measure. You find average shareholders' equity by adding the equity at the period's start and end, then dividing by two. Net income comes from the income statement for the full fiscal year, while equity is from the balance sheet.
Using ROE to Evaluate Stock Performance
You can use ROE to estimate growth rates for stocks you're considering, especially if it's in line with or above the peer group average.
To estimate future growth, multiply ROE by the retention ratio—the percentage of net income reinvested. The sustainable growth rate (SGR) is ROE times the retention ratio, or alternatively ROE times (1 minus payout ratio). For example, a company with 15% ROE and 70% retention has an SGR of 10.5%, while one with 90% retention hits 13.5%. If a stock grows slower than its SGR, it might be undervalued or facing risks worth investigating.
Using ROE to Identify Risks
A high ROE is generally positive, especially if net income is large relative to equity due to strong performance. But an extremely high ROE might stem from a small equity base compared to net income, signaling risks like inconsistent profits or too much debt.
Inconsistent profits can inflate ROE if past losses reduce equity, making current profits look outsized. Excess debt lowers equity (since equity is assets minus debt), boosting ROE artificially, like when companies borrow to buy back stock and inflate EPS without real growth.
Negative net income or equity creates an artificially high or negative ROE, which isn't useful for analysis. Generally, stick to stocks with average or slightly above-average ROE compared to peers to minimize risks.
Limitations of Return on Equity
ROE has its limits—you can't use it for companies with negative ROE from net losses or negative equity, as it's not a true return. Also, it doesn't work well for comparing across industries due to varying margins and structures. Remember, ROE is just one metric; combine it with others for a full picture of financial health.
Return on Equity vs. Return on Invested Capital
ROE focuses on profits from shareholders' equity, but return on invested capital (ROIC) goes further by looking at profits after dividends from all capital sources, including debt. ROIC shows how well a company uses all available capital to make money.
Return on Equity and DuPont Analysis
DuPont analysis breaks down ROE into components for deeper insights. The three-step version is ROE equals net profit margin times asset turnover times equity multiplier. The five-step digs into earnings before tax over sales, sales over assets, assets over equity, times (1 minus tax rate). This helps you see what's driving ROE changes, like efficiency or leverage, compared to history or competitors.
The Bottom Line
ROE compares a company's income to its shareholders' equity to show profitability and efficiency. It's useful, but not complete—pair it with other metrics for a full view of performance, growth, and stability.
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