How to calculate ROE (Return on Equity) to determine the profitability of the company
If you are thinking of investing in a company, you will need a reliable way to measure the return on that company's capital. After all, what is the point of investing if the returns do not pay off? Return on equity, or ROE for short, does exactly that. It measures the profitability of a company, and is one of the most important metrics in business and investment.
But how is ROE calculated? And most importantly, once you know the result, how do you interpret it? A negative ROE is not always an indication of risk capital, and sometimes a positive ROE can be a mirror for larks.
Find out in our article how ROE is calculated and how to compare it with other company balance sheet ratios.
What is Return on equity (ROE)?
Return on equity (ROE) is a way for investors to measure the financial performance of a company. More specifically, it is the profitability of the company in relation to its equity. ROE measures corporate performance by comparing after-tax income with total shareholders' equity. ROE appears in the list of balance sheet indicators that shareholders use to compare it to management performance.
ROE, Return on equity, is also sometimes called return on net assets because shareholders' equity is equal to a company's net assets, after debt.
Since ROE measures the percentage of investors' capital that has been converted into income, it is a good way to determine how efficiently your company is managing your invested money. The rate of satisfaction will depend on benchmarks such as industry, size and comparison with other similar companies. In general, a company with a relatively higher ROE has a greater chance of generating income using the invested capital of stakeholders.
How is Return on Equity (ROE) calculated?
The basic formula for calculating ROE is:
ROE= ( Net Operating Income / Equity (equity) ) x 100
Net operating income is the final profit - before dividends on ordinary shares are paid - reported on a company's income statement. Free cash flow (FCF) is another form of profitability and can be used instead of net income.
Shareholders' equity is the assets minus liabilities on a company's balance sheet and is the book value that remains for shareholders if a company settles its liabilities with reported assets.
Note that ROE should not be confused with Return on total assets (ROTA). The latter is also an indicator of profitability. However, ROTA is calculated by taking a company's earnings before interest and taxes (EBIT) and dividing them by the company's total assets.
ROE can also be calculated in different periods to compare its change in value over time. By comparing the change in the ROE growth rate from one year to the next or from one quarter to the next, for example, investors can track changes in management performance.
Practical example of ROE calculation
Let us try to calculate ROE using an example. First of all, let us imagine that company X has a net income of EUR 10 million in one year. At the beginning of the year, the average net worth of the shareholders was EUR 25 million. You were able to find these numbers by consulting the income statement and balance sheet of company X.
Using these numbers, ROE would be calculated this way:
ROE = Net Income / Average Net Worth
ROE = (10,000,000 / 25,000,000) = 0.4
ROE = 0.4 x 100% = 40%.
Following the ROE formula, we calculated that company X's return on equity during that year was 40%.
Correctly interpreting the ROE result
Measuring the performance of a company's ROE against that of its industry is only one possible comparison.
For example, in the fourth quarter of 2020, Bank of America Corporation had an ROE of 8.4%. According to the Federal Deposit Insurance Corporation, the average ROE of the banking sector in the same period was 6.88%. In other words, Bank of America outperformed industry expectations.
However, the FDIC's calculations included all types of banks, including commercial, consumer, and community banks. Since Bank of America is, in part, a commercial lender, one has to look at the corresponding value in the commercial banking sector. The ROE for commercial banks was 5.62% in the fourth quarter of 2020. We can, therefore, conclude that its ROE still turns out to be higher than that of other commercial banks.
Therefore, it is not only important to compare a company's ROE with the industry average, but also with similar companies within that industry.
When evaluating companies, some investors also use other indicators, such as Return on capital employed (ROCE) and ROI, Return on investment and ROA, Return on assets. Investors often use ROCE instead of the standard ROE to judge the longevity of a company. In general, both are more useful indicators for capital-intensive companies, such as utilities or manufacturing.
Correctly interpreting the ROE result
ROE will always tell a different story depending on the financial data, e.g. if equity changes due to share buybacks or income is small or negative due to a one-off loss. Understanding the components that caused a negative ROE is crucial. Let's look at all possible scenarios.
What is a negative ROE?
There may be circumstances in which a company's net worth is negative. This usually occurs when a company has suffered losses over a period of time and has had to borrow money in order to stay in business. In this case, liabilities will be greater than assets.
Thus, even if the company has generated considerable profits in the current year and is therefore profitable from a financial point of view, the result will be a negative ROE.
Is too high an ROE positive?
One might think that shares with a high ROE are a great value, but this is not always the case. As an investor, you have to be careful and make sure that the company you are interested in can offer a solid ROE, but also grow at a sustainable rate. If you find a company with a very high ROE, you should do a thorough analysis of its finances.
You should look for possible problems such as inconsistency of profits, excess debt and negative net income.
Profit inconsistency
A high ROE can sometimes signal inconsistent profits, so be very careful. The ROE formula itself is explanatory of this situation. Let us say that company Z has made losses for several years in a row. These losses are recorded in the equity section of the balance sheet as retained losses. Being a negative number, it reduces the amount of equity.
Now, let us say that company Z suddenly has a sales peak and performs very well in the current year. When the ROE is calculated for that year, it will result in high net income, which will be divided by a very small denominator, net worth. Due to simple mathematics, this will result in a deceptively high ROE.
Excess debt
Another common problem that arises with a high ROE is excess debt. Remember, equity equals net assets after debt. If a company has borrowed aggressively to stay afloat, again you have an example where the denominator becomes very small. This results in a high ROE that could lead you astray.
Negative net income
Last but not least, negative net income can be another trap for investors. It was mentioned earlier that ROE should not be calculated if net income or net worth is negative. Both negative net income and negative net worth can create a falsely high ROE. If a company has to report a net loss, rather than net income, then ROE should not be calculated.
Do you still have questions on the calculation of ROE? If you need clarification, please write to us in the comments section.
Article translated from Italian