One of the most important profitability metrics for investors is a company’s return on equity (ROE).
Return on equity reveals how much after-tax income a company earned in comparison to the total amount of shareholder equity found on the balance sheet.
Return on equity is an easy-to-calculate valuation and growth metric for a publicly traded company.
It can be a powerful weapon in your investing arsenal as long as you understand its limitations and how to use it properly.
What Does ROE Tell You?
Whether ROE is deemed good or bad will depend on what is normal among a stock’s peers.
For example, utilities have many assets and debt on the balance sheet compared to a relatively small amount of net income.
A normal ROE in the utility sector could be 10% or less. A technology or retail firm with smaller balance sheet accounts relative to net income may have normal ROE levels of 18% or more.
Return on Equity provides a simple metric for evaluating investment returns.
By comparing a company’s Return on Equity to the industry’s average, something may be pinpointed about the company’s competitive advantage.
The return on equity ratio or ROE is a profitability ratio that measures the ability of a firm to generate profits from its shareholders investments in the company.
In other words, the return on equity ratio shows how much profit each dollar of common stockholders’ equity generates.
This is the basic formula for calculating Return on Equity is:
ROE = Net Income / Shareholders’ Equity
Return on Equity Formula Drivers
While the simple return on equity formula is net income divided by shareholder’s equity, we can break it down further into additional drivers.
What is a good ROE?
As with return on capital, a ROE is a measure of management’s ability to generate income from the equity available to it.
ROEs of 15–20% are generally considered good. ROE is also a factor in stock valuation, in association with other financial ratios.
ROE may also provide insight into how the company management is using financing from equity to grow the business.
A sustainable and increasing ROE over time can mean a company is good at generating shareholder value because it knows how to reinvest its earnings wisely, so as to increase productivity and profits.
In contrast, a declining ROE can mean that management is making poor decisions on reinvesting capital in unproductive assets.
What happens if ROE is negative?
Return on equity (ROE) is measured as net income divided by shareholders’ equity. When a company incurs a loss, hence no net income, ROE is negative.
A negative ROE is not necessarily bad, mainly when costs are a result of improving the business, such as through restructuring.
Example of Return on Equity in Use
For example, imagine a company with an annual income of $1,800,000 and average shareholders’ equity of $12,000,000.
Consider Apple Inc. (AAPL)—for the fiscal year ending Sept. 29, 2020, the company generated US$59.5 billion in net income. At the end of the fiscal year, its shareholders’ equity was $107.1 billion versus $134 billion at the beginning. Apple’s ROE, therefore, is 49.4%, or $59.5 billion / (($107.1 billion + $134 billion) / 2).
Compared to its peers, Apple has a very strong ROE.
- Amazon.com Inc. (AMZN) had a return on equity of 27% in 2020,
- Microsoft Corp. (MSFT) 23% in Q3 2020, and
- Google—now know as Alphabet Inc. (GOOGL) 12% for 2020
What is the difference between Return on Assets (ROA) and ROE?
ROA and ROE are similar, in that they are both trying to gauge how efficiently the company generates its profits.
However, whereas ROE compares net income to the net assets of the company, ROA compares net income to the company’s assets alone, without deducting its liabilities.
In both cases, companies in industries where significant assets are needed for operations will likely show a lower average return.
Limitations of Return on Equity
A high ROE might not always be positive. An outsized Return on Equity can be indicative of a number of issues such as inconsistent profits or excessive debt.
Also, a negative ROE due to the company having a net loss or negative shareholders’ equity cannot be used to analyze the company, nor can it be used to compare against companies with a positive ROE.
So, ROE is one of the major return metrics being used by the equity investors as it captures the quality of the investment validated through actual figures.
However, it is important that as an investor one can read between the lines of financial items so that they don’t end up being misled by the ROE per se.