Return on Equity (ROE) – A Complete Guide

Infographic that explains what Return on Equity (ROE) is, its formula, its interpretation. and its advantages and limitations.

One of the keys to successful investing is being able to spot value investments. Uncovering value stocks demands a company’s in-depth fundamental analysis, an analysis of its financial statements and a comparison with its competitors in the same industry. Investors use many metrics to compare the performance of competing companies in an industry to find out where they should put their money to maximize their returns. Return on Equity (ROE) is one metric that shows how profitable a company is. This financial ratio indicates how efficiently a company turns investor money into profits.

What Is Return on Equity?

The Return on Equity ratio gives insight into how efficiently a company uses its shareholder equity to grow its business. In addition, by comparing a company’s Return on Equity ratio to the industry average, this metric may also indicate how strong a company’s competitive advantage is and how successful the company is in the industry. 

ROE is an essential financial measure for analysts and investors because it calculates a company’s profitability. It is the ratio of a corporation’s net income and shareholder equity, and it shows how much profit the corporation earns for every dollar invested by its shareholders. By comparing a company’s net earnings to its shareholder equity, ROE helps determine how good a company is at converting investors’ money into company profits. Therefore, Return on Equity is a powerful indicator that helps investors identify potentially lucrative investment opportunities.  

How Do You Calculate Return on Equity?

Return on Equity is generally expressed as a percentage. The basic formula for calculating ROE involves dividing a company’s net earnings by its average shareholders’ equity and multiplying the result by 100. 

Return on Equity formula

Typically, net income is a company’s profit minus its short and long-term liabilities during a specified period, typically a year. It is often referred to as bottom-line profit or net income and can be found on a company’s income statement. On the other hand, shareholder equity is the shareholders’ claim on the company’s assets. Shareholder equity is calculated by taking the total assets and deducting the total liabilities. Shareholder equity can be found on the company’s balance sheet.

An income statement shows how profitable a company is over a given period. In contrast, a balance sheet provides a snapshot of a company’s assets and liabilities at one point in time. Therefore, to reconcile the time inconsistency in the Return on Equity formula, you should use the average shareholder equity for the same specified period that the income statement is based on. So, for example, the 2020 Average ROE is 2020 net earnings divided by the average shareholder equity for 2020.

How to Interpret Return on Equity?

A company’s ROE is used to evaluate its profits and investment returns within and in its industry. Investors and analysts use this ratio to see if a company’s Return on Equity increases over time and compare a company’s performance against the standard performance in the industry. Typically, a higher ROE is better. However, this is not always the case. When evaluating a high Return on Equity, you should not just take the number at face value. Instead, you should look at the underlying reasons why this number is high. 

What is Better – A High or Low ROE?

Return on Equity measures a corporation’s profitability and efficiency. Typically, a high ROE suggests that the management team is highly efficient at utilizing investor money for growth or increasing profits without needing much capital. In addition, a rising ROE indicates that the company is successful at improving a company’s profitability and efficiency in the long term, which is very appealing to potential investors. 

In contrast, a low or declining ROE generally suggests that the company is not well-managed, not using its resources efficiently, and might be investing its earnings in the wrong places. However, a low or a negative ROE is not necessarily harmful in startup companies or when costs result from improving or restructuring the business.

What Is a Good ROE?

Unfortunately, there is no easy answer to this question. When comparing a company’s ROE, it is best to compare it to its peers in the same industry or sector. However, competitor information is not always readily available, and finding this information can be a time-consuming and challenging process. Therefore, investors often use the long-term S&P 500 average ROE of 14% as a benchmark for comparison purposes because it is easier. When using the 14% average, an ROE ratio of less than 10% should be considered undesirable.

As mentioned before, the best benchmark to use when comparing ROE ratios is the industry average. The interpretation of a company’s ROE depends on the average ROE in its industry or sector. Some industries and sectors tend to have higher Return on Equity ratios than others. For example, the average ROE for the technology and financial sectors is higher than the average ROE in the energy and utility sectors.

This is why the comparison of Return on Equity is only meaningful for companies within the same industry or sector. For example, suppose a company’s ROE ratio is higher than the industry average. This higher than average ROE ratio should be considered a good thing. It signals that the company uses its shareholder equity more efficiently for profit generation than most other companies in the industry. In contrast, a lower than average ROE denotes that the company is less efficient in using its shareholder equity.

Reasons Why ROE Might Be Artificially High or Low

Although a high ROE typically is a good sign and may indicate that a company is making efficient use of its investor capital, this is not always the case. There might be other reasons for a high Return on Equity ratio that might make you think twice about investing in the company. 

This is why you should not look at this metric in isolation and always use it in conjunction with further analysis to shed light on why the ROE is so high. Here are some of the most common reasons why a high ROE might be deceiving. 

Share Buybacks and High Dividend Payout Ratio

Investors typically view share buybacks and high dividend payouts as positive signs for company growth in the future. Therefore, share buybacks and cash dividend distributions will often result in investors rushing to buy the stock. Although neither will affect net income (the numerator in the ROE formula), both will decrease shareholder equity (the denominator in the ROE formula), increasing the Return on Equity ratio. 

It is good practice for a company to use its excess capital to buy back some of its shares and pay dividends. Share buybacks are an indirect way of returning excess capital to shareholders, whereas paying dividends is a direct way to share profits with shareholders. 

However, sometimes companies use borrowed money to fund these buybacks and dividend distributions to make their financials look better than what they are. This is problematic and deceiving. It appears that the company is doing well because its Return on Equity has increased. As a result, uninformed investors might not realize that its debt has increased dramatically, and its ROE is artificially inflated because debt is not considered in the Return on Equity calculation. 

Share buybacks do not only make a company’s Return on Equity increase but may also make other evaluation metrics look more favorable to investors. For example, stock buybacks also increase a company’s EPS (Earnings per Share). By reducing the number of outstanding shares, a company’s EPS automatically gets a boost because its annual earnings will now be divided by fewer outstanding shares, not because its earnings have grown.

Erratic Earnings and Negative Net Income

It is essential to understand that when a company’s net income or its shareholders’ equity is negative, ROE should not be used or used with caution!

Sometimes, a very high ROE can point to inconsistent earnings due to previous years’ losses, creating some confusion. For example, when a company has been losing money for many years, the losses can accumulate and, in turn, reduce stockholder equity. Then, a single profitable year can result in a high ROE as shareholder equity (the denominator in the ROE formula) has shrunk due to the previous years’ losses. So, although the ROE is high, in reality, the company is in poor financial health and should not be considered as a good investment opportunity.

Excessive Debt

Debt is another significant factor that can cause an inflated Return on Equity. One of the main disadvantages of the ROE ratio is that it does not consider debt. When a company borrows excessively, shareholder equity decreases because shareholder equity is calculated by deducting all debt from the company’s assets.

So, the higher a company’s debt, the lower its shareholder equity and the higher its Return on Equity. This high ROE can be deceiving when a company is highly leveraged and might not be financially stable. By paying down debts, a company will become financially more sound. However, paying down debt if net income stays the same might deter potential investors from investing because it decreases the company’s ROE. Although in reality, the company’s financials are improving because its debt is declining.

An example of how excessive debt can inflate an industry’s ROE is the U.S. airline industry. Due to Covid-19, many airlines had to be bailed out because of their excessive debt. Due to low-interest rates over the last decade, many U.S. airlines borrowed money to buy back billions in shares to make their share price and Earnings per Share look more attractive to investors. Then, when Covid-19 hit, it became apparent how bad a shape the airline industry was in with all its debt, and the only way to save the industry was a bailout.  

A better metric to use in case of excessive debt is the Return on Invested Capital or (ROIC), which considers the usage of debt in generating profits. In its simplest form (excluded dividends), the formula is:

ROIC = Net income / (Shareholders’ Equity + Total Debt)

Write-downs​

A write-down is the accounting term used to describe a reduction in the book value of an asset to match its current market value. In other words, the asset has become overvalued in the market. A write-down can reduce shareholder equity and artificially increase ROE in the years following the year the one-time charge to income took place. It is a paper entry only and does not mean that the company has improved the efficiency of its operations.

Please note that a high ROE is generally a good sign because it can indicate that a corporation’s prospects and profits are expected to grow. However, further research is often needed to shed some light on whether a high Return on Equity is a valid reason to invest in the company or some scheme to make the company look more attractive to potential investors.

Example of Return on Equity

To better understand Return on Equity and its calculation, let’s have a look at Facebook’s ROE. According to its filings, Facebook’s net income for 2020 was $29.15 billion, while its stockholder equity was $128.29 billion. Using these figures, Facebook’s Return on Equity can be calculated as follows:

Return on Equity = (29.15 / 128.29) x 100 = 22.7%

This ROE calculation suggests that Facebook’s annual net income was about 22.7% of its shareholder equity. This ROE is quite impressive, looking at the industry average of about 17% during that same period. It indicates that in 2020, Facebook generated high profits with relatively little capital.

Return on Equity weighs a company’s profits against its shareholder equity. In this case, $1 of Facebook’s equity generated almost  $0.23 in earnings.

However, as financial leverage or debt can artificially raise the Return on Equity ratio, it is essential to look at Facebook’s debt in 2020. It turns out Facebook did not have any debt in 2020! This means the company’s returns were purely driven by its equity capital, indicating that Facebook was using its shareholder equity exceptionally efficiently.

Return on Equity and Dupont Analysis

An excellent way to get further insight into a company’s performance is to break down the Return on Equity into three components using the DuPont Analysis. The DuPont formula is designed to help investors get a clearer picture of a stock’s profitability by focusing on three key financial ratios to identify strengths and weaknesses. The first ratio is the net profit margin which measures operating efficiency. The second one is the asset turnover ratio which measures asset efficiency. Finally, the last ratio that identifies strengths and weaknesses is the equity multiplier ratio, which measures leverage efficiency. Below you can find the formula for the Dupont analysis and its three financial ratios;

Dupont formula

Increasing any of these three ratios will raise the ROE ratio. For example, if a company’s net profit margin increases over time, it manages its operating and other expenses well, and its Return on Equity should increase. An increase in the asset turnover ratio suggests that the company is efficient at utilizing its assets, thereby generating more sales per dollar of assets. Finally, the equity multiplier signifies the portion of the return on equity that results from debt. It is helpful to use financial leverage to fund a company’s activities. However, using too much debt will increase the ROE ratio and make it look like a good investment although higher debt makes the company a more risky investment.

Please note that the DuPont formula gives the same values for Return on Equity as the classic ROE formula. Its main advantage is that it shows investors what specific financial activities affect the ROE the most.

ROE versus Return on Assets (ROA)

Return on Assets (ROA) is another financial ratio that gauges a company’s ability to generate returns from its assets. Although ROE and ROA seem pretty similar in what they measure, there are some differences.

While Return on Equity compares net income to net assets, Return on Assets compares a company’s net income to its total assets without deducting its liabilities. In other words, the big difference between ROE and ROA is debt or financial leverage. ROA takes debt into consideration while ROE ignores debt..  

Return on Assets is calculated by dividing a corporation’s net income by its total assets. Total assets can be found on the balance sheet and equals shareholder equity plus liabilities. This means that if a company has no debt, its shareholders’ equity and its total assets are the same, resulting in the ROE and ROA being the same.

Return on Assets formula

So, when a corporation borrows money, its Return on Equity will be higher than its Return on Assets because ROA’s denominator (shareholders’ equity plus debt) will increase, resulting in a lower ROA. On the flipside, the ROE does not change because it does not take debt into consideration.

For example, a corporation has a net income of $10 million, shareholders’ equity of $50 million, and liabilities of $20 million. The industry’s average ROE is 15%. This results in the following ratios:

ROE = ($10 million / $50 million) * 100 = 20%

ROA = ($10 million / ($50 million + $150 million)) * 100 = 5% 

Here you can see that Return on Equity does not tell you anything about how efficiently the corporation uses the capital it gets from debt (for example debt from borrowing or bond issues) because ROE completely ignores debt in its calculation

In the example above, the corporation’s ROE of 20% might look favorable to investors as it is higher than the industry’s average of 15%. However, because ROE ignores debt, ROE does not give the full financial picture. The corporation’s Return on Assets is only 5%, which is pretty low for the industry. Its large debt burden puts the corporation at high risk which will make it a less desirable investment option.

It is clear that when you use both ROE and ROA you get a more realistic picture of a corporation’s management effectiveness and financial performance. For example, a company with a high Return on Equity ratio, a sound Return on Assets ratio, and reasonable debt levels is doing a good job generating profits from its assets. However, a company with a high ROE, a low ROA and considerable debt might give investors the wrong impression about its profitability and effectiveness.

Limitations of ROE

ROE should not be used in isolation – Though ROE is a measure of financial performance and one of the most popular financial metrics used by investors, it does not tell the whole story. Therefore, it should not be the only metric used to gauge a firm’s profitability and efficiency in generating profits. When used alone, ROE can result in various misleading conclusions.  

To get a better view of a company’s financial situation it is best to use ROE in conjunction with other ratios such as ROA, ROCE (Return on Capital Employed), ROI (Return on Investment), and EPS. 

Return on Equity can be manipulated using various accounting caveats – Another limitation of ROE is that companies can intentionally distort it using loopholes in accounting. For example, It is easy to boost the Return on Equity ratio by using inflated earnings or hiding assets away from the balance sheet, representing the company as profitable, though in reality it may not be. In addition, a high ROE is not always a good thing. Inconsistent profits or excessive debt can result in an artificially inflated ROE, indicating several issues.

ROE should not be used when negative – Startup companies typically report losses for many years before turning profitable. When a company’s net income is negative, its ROE will be negative as well. A negative ROE makes Return on Equity an unsuitable metric for predicting a startup’s growth and profitability potential. In addition, companies that are undergoing significant restructuring might also have a negative ROE, so caution is advised when using an ROE that is negative.

Conclusion

Return on Equity is one of the most valuable financial ratios for investors looking to find value stocks to invest in. ROE indicates how efficiently a company can generate revenue from investor money. Whether a company’s ROE is good or bad depends on the industry’s average ROE. 

A good rule to follow is to look for a Return on Equity ratio equal to or just above the average for its peers in the same industry. What most investors are looking for is a sustainable growth rate. A growth rate far below or above this sustainable growth rate will require further research. 

Please remember that ROE is only a single financial ratio and should never be used in isolation. As with any other financial analysis, it is essential to use a variety of financial metrics to get a 360-degree view of a company’s financial performance and efficiency.

Vikram R
Vikram Raghavan is a value investor, technologist, and Finexy co-founder. In addition to stock market investing, Vik also invests and advises startups on growth marketing and product management. Vik's work is focused on themes of marketplaces, micro-entrepreneurship, marketing automation, and user growth. Previously, Vikram led product and growth teams at Overstock.com, focusing on efforts across acquisition, new user experience, churn, and notifications/email. He holds an MBA in Finance from Temple University and a B.S. in Computer Information Systems and Finance from Bemidji State University.