What is Return on Equity
Return on equity is a financial ratio that measures the company’s profitability by the comparison between the net income and the shareholders’ equity, also known as the return on shareholders’ equity. The return on equity shows how many dollars of net income a company generated for each dollar of the owner’s equity.
The higher percentage of ROE reflects the company had a high ability to generate profit by utilizing the shareholders’ equity. In contrast, the lower ROE ratio reflects the company’s poor ability to generate profit with the shareholders’ equity.
Normally, the analysts use the return on equity (ROE) to determine the rate of return that shareholders will receive on the investment in the company and to measure how efficiently using equity to grow the company by expressed as a percentage. Unlike the other return on investment (ROI) ratio, return on equity (ROE) is a return on investment from the investors’ perspective, not the company.
The ROE helps investors understand the growth they are getting from investing in a company’s stock to evaluate how a company is using its resources to drive growth The ROE tells an investor a lot about the effectiveness of a company’s executive team and the overall strength of its business.
Return on Equity Formula & Example
The return on equity can be calculated by dividing the company’s net income by the average shareholders’ equity amount, or the following return on equity formula:
ROE = (Net income / Average shareholders’ equity) x 100
Where:
The average shareholders’ equity is calculated by dividing the sum of the equity at the beginning of the period and the ending of the period by 2.
For example, the Feriors company had the following financial results for last year:
- Net income: $1,000,000
- Shareholders’ equity at the beginning of the year: $2,500,000
- Shareholders’ equity at the ending of the year: $2,500,000
Average shareholders’ equity = (2,500,000 + 2,500,000) / 2 = $250,000
ROE = (1,000,000 / 2,500,000) x 100 = 40%
From the above example, the Feriors can generate 40 cents for each $1 of shareholders’ equity.
The High ROE Trap
To increase the return on equity, the company does not just generate more income from the shareholders’ equity as we mention above. The return on equity value can be increased with these inappropriate methods:
- Share repurchases (aka stock buybacks)
- Overleveraging (borrowing more debt to increase sales)
Share repurchases: When the company repurchases its shares the outstanding share will be reduced, then the ROE increase due to the smaller denominator.
Overleveraging: When the company borrows more debt to sell more products the net income will increase, then the ROE will increase due to the increased net income. However, the return on equity equation does not include the company’s debt, which means you possibly not recognized that the company overleveraging to boost the ROE. Overleveraging has a negative impact on the increased interest payment which is the risk of default.
Frequency Asked Questions
Return on equity is a financial ratio that measures the company’s profitability. The value of ROE shows how many dollars of net income a company generated for each dollar of the owner’s equity.
The return on equity can be calculated by dividing the company’s net income by the average shareholders’ equity amount, or the following return on equity formula: ROE = (Net income / Average shareholders’ equity) x 100
The higher percentage of ROE is a good return on equity value, it reflects the company had a high ability to generate profit by utilizing the shareholders’ equity.
