- Return on equity (ROE) is a measure of financial performance that shows how profitable a business is.
- ROE is calculated by dividing a company’s annual net income by its equity.
- While useful, ROE can sometimes be misleading and can be skewed by dishonest accounting.
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The key to value investing is developing a talent for spotting undervalued companies. The value investor is looking for hidden gems – companies with strong management, strong financial performance and relatively low stock prices.
Uncovering valuable stocks requires careful analysis of a company’s fundamentals, but there are certain metrics that help you separate the wheat from the chaff quickly. Return on equity (ROE) is one of them – it tells you how well a business is making profit from the cash invested.
What is return on equity (ROE)?
Return on equity (ROE) is a financial ratio that tells you how much net income a business generates per dollar of invested capital. This percentage is essential because it helps investors understand how efficiently a company uses its capital to generate profit.
Understand how ROE works
ROE is a useful metric for evaluating a company’s returns on investment in a particular industry. Investors can use ROE to compare a company’s ROE to the industry average to get a better idea of how that business is performing relative to its competitors.
A higher ROE indicates that a company is making efficient use of its shareholders’ equity to generate income. A low ROE means that the company earns relatively little compared to the equity of its shareholders.
An upward trend in ROE is also a good sign. “While a company’s absolute ROE is important, how ROE has changed over time – and what drove the change – may be even more relevant,” says JP Tremblay, professor of finance at Daniels College of Business from the University of Denver. .
ROE can also be used to help estimate a business’s growth rates – that is, the rate at which a business can grow without having to borrow additional money.
How to calculate the ROE
To calculate ROE, divide a company’s annual net income by its equity. Multiply the result by 100 to get a percentage.
Net revenue: This is the income of a business after deducting expenses. The annual net income of a company is carried over to its income statement
Equity: This is the claim that shareholders have on a company’s assets after its debts have been paid. Equity is shown on the balance sheet.
How to calculate ROE in Excel
To calculate ROE in Excel, enter the annual net income of a business in cell A2. Then enter the value of their equity in cell B2. In cell C2, enter the formula: = A2 / B2 * 100. The resulting figure will be the ROE expressed as a percentage.
ROE can be negative. But that doesn’t necessarily mean the business has negative cash flow. Dr. Robert R. Johnson, professor of finance at Creighton University’s Heider College of Business, notes that “businesses that lose money on an accrual basis can have negative ROE but positive cash flow.” . A negative ROE isn’t necessarily bad, but it deserves further investigation.
The DuPont formula
One way to get additional information about ROE is to break it down into components using a framework called DuPont analysis. This more advanced analysis breaks down ROE into three ratios, helping analysts understand how a business has achieved its ROE, strengths, and opportunities for improvement.
- The first report is net profit margin (net income divided by sales). A business can improve its profit margins by making more money on each unit it sells.
- The second report is asset turnover (sales divided by total assets). A business can improve asset turnover by increasing sales while keeping total assets constant.
- The third gear is financial leverage (total assets divided by equity). A business can improve its ROE by borrowing money and earning more from that money than it costs.
Increasing any of these ratios increases ROE. “Two companies can have the same ROE and get there in completely different ways,” says Johnson.
Other uses of ROE
An unusual or extremely high ROE may prompt an analyst to do more research.
- This can signal negative net income. If a business shows both negative income and negative equity, it could result in a deceptively high ROE. An analyst will want to verify that net income and equity are positive when interpreting ROE.
- This can signal inconsistencies in profits. Imagine that a company has years of losses on its equity. A year with significant net income and artificially low equity could result in extremely high ROE. When the ROE is sky-high, most analysts dig to check the company’s revenue history.
- This can signal excess debt. Johnson notes that an easy – but risky – way for a profitable business to increase ROE is to borrow money. This is called the leverage effect. “Leverage works when you can make more money with borrowed money than it costs you,” Johnson says. “Of course, leverage is often called a double-edged sword because it can magnify losses when you make less money (or lose money) on borrowed funds than they cost you. . “
ROE vs return on assets vs return on invested capital
ROE tells investors how much income a business generates from a dollar of equity. It has some similarities to other measures of profitability such as return on assets or return on invested capital, but it is calculated differently.
Return on assets (ROA) tells you to what extent a company’s profits are generated by fixed investments such as property, plant and equipment. The formula for ROA is almost the same as for ROE, but it uses total assets as the denominator while ROE uses equity.
Return on invested capital (ROIC) also measures profitability over investment, but it adds a bit more complexity: it tells you how much net income (after dividend payments) a business generates from all its capital, both debt and equity. ROIC is calculated using net income minus dividends as the numerator and the sum of a company’s debt and equity as the denominator.
Each of these metrics is used to assess and compare companies based on how efficiently their management is using their financial resources to generate profits, but each takes a different angle.
While this is one of the most important financial metrics for equity investors, ROE doesn’t always tell the whole story.
For example, it can be deceptively low for new businesses, where there is a great need for capital while incomes may not be very high. Likewise, certain factors, such as excessive debt, can inflate a company’s ROE while adding significant risk.
Another limitation of ROE is that it can be intentionally distorted using accounting loopholes. Inflated profits or hidden assets on the balance sheet can increase ROE and make a business look more profitable than it actually is.
Because of these limitations, the diligent investor must undergo a comprehensive analysis of a company’s financial performance using ROE as one of many measures.
The financial report
ROE is one of the most important financial ratios for the equity investor looking for good value companies. It is a simple and practical indication of the ability of a business to generate income from the money invested. A high and stable ROE is usually better, but the absolute number should be considered in the context of the industry. It is also a good sign if the ROE increases over time.
Use ROE to sift through potential stocks and find companies that turn invested capital into profit quite effectively. This will give you a short list of candidates on which to perform a more detailed analysis.