Finrepo » Company's Financial Accounting » Financial Ratios: Formulas and Interpretation » Return On Equity (ROE): Brief Summary


Return On Equity (ROE): Brief Summary

Return On Equity (ROE): Brief Summary

DEFINITION:

The return on equity ratio (ROE; in Finnish, oman pääoman tuotto) reveals the ability of a firm to generate profits from its shareholders investments. Ratio is used to:

  • measure the financial performance of a business;
  • measure of a company's profitability in relation to stockholders’ equity;
  • determine how well a company uses investments to produce income;
  • estimate the dividend growth rates and the percentage return earned by equity shareholders;
  • compare the profitability of companies within a sector / industry.

FORMULAS for calculations:

Ratio is usually expressed as a percentage.

\[ {ROE} = {Net\ Income \over Total\ Stockholders’\ Equity} * 100 % \]

WHERE:

  • Net Income = Net Profit = Revenue – COGS (Cost of Goods Sold) – Operating Expenses – Interest – Taxes

For detailed assessment of the company’s profitability could be used DuPont Analysis: it helps to understand which component is impacting ROE more. DuPont technique for ROE calculation with additional steps:

ROE calculation: 3-step DuPont Analysis

\[ {ROE} = {Net\ Income \over Revenue} * {Revenue \over Total\ Assets} * {Total\ Assets \over Total\ Stockholders’\ Equity} =\] \[ {Net\ Profit\ Margin\ * Asset\ Turnover\ * Equity\ Multiplier} =\] \[ {ROA * Equity\ Multiplier} \]

Thus, such factors, as Net Profit Margin, Asset Turnover, Leverage (Equity Multiplier), directly affect changes in a company's ROE %.

ROE calculation: 5-step DuPont Analysis

\[ {ROE} = {Net\ Income \over Pre-Tax\ Income} * {Pre-Tax\ Income \over EBIT} * {EBIT \over Revenue} * {Revenue \over Total\ Assets} * {Total\ Assets \over Total\ Stockholders’\ Equity}= \] \[ {Tax\ Burden\ * Interest\ Burden\ * Operating\ Margin\ * Asset\ Turnover\ * Equity\ Multiplier} \]

WHERE:

  • Operating Income = EBIT
  • ROA, Return on assets - profitability of a business in relation to its overall assets.
  • Net profit margin - measure of operating efficiency; operating income per euro of sales.
  • Asset Turnover - asset utilization efficiency; the sales amount generated per euro of assets.
  • Equity Multiplier - financial leverage; measures the level of debt financing in a business.
  • Operating margin - operating income per euro of sales.
  • Interest burden – the proportion of operating profit remained after paying interest costs on the borrowed funds.
  • Tax burden – the proportion of net profits retained after paying taxes.

RESULT INTERPRETATION:

  • Depend on the company’s industry and competitors.
  • The company's and its competitors’ historical ROE data have to be investigated.
  • A good ROE is equal to or just above the average for the same group / industry.
  • ROE for stocks: between 15% and 20% is a desirable resulting number.
  • Long-term average ROE for companies in the list of S&P 500, which is equal to around 14% - good result, and less than 10% - poor one.
  • Stable economics: more than 12-15% is considered as a desirable result.
  • High ROE is usually better than the low one (But this is not always the case, sometimes it indicates risk!)
  • High ROE could indicate that a company is more successful (efficient) in generating profit, and, as a result, this could mean possible higher returns to investors; as high return on equity drives up company's share price.
  • But note: Significantly high ROE compared with an average in the industry is not always good sign: high ROE% ratio may indicate, for instance, that the firm is highly levered (has lot of debts).
  • Low ROE may indicate that the company ineffectively reinvests profits, less efficient usage of equity capital.
  • Note: the accounting data used for these calculations can be manipulated by the management to hide discrepancies. Thus, it is important to note that there are many other financial metrics should also be considered when evaluating the company's financial position.

EXAMPLE:

A company's ROE is equal to 20 %:

This means that the company generated € 0.20 of profit for every €1 of total equity.

ROE calculation. Example.

  previous page   next page