Return On Equity (ROE) Meaning, Formula & Calculation

To be a successful investor, you need to have a good understanding of the various financial metrics associated with the stock market. One such key metric is Return on Equity (ROE). ROE is an important indication of how successfully an organisation uses its equity to make profits. For investors trying to evaluate a company's profitability, ROE is a crucial instrument.

Let us look further into what Return on Equity (ROE) is, how it is calculated, and why it is significant. 

What is Return on Equity (ROE)?

Return on Equity is a measure of a company's profitability relative to the equity capital provided by its shareholders. Simply said, it indicates how much profit a company makes with the money shareholders have invested. The greater the ROE, the more effectively an organisation utilises its equity base to increase profits.

A 20% ROE indicates that for every ₹ 100 invested by shareholders, the firm earns ₹ 20 in net profit. This ratio is especially essential for investors since it allows them to determine how efficiently their money is being used.

Difference Between Rate of Return and Return on Equity

It's common to confuse return on equity with the rate of return, but they serve different purposes and measure different aspects of financial performance.

• Return on Equity: This metric assesses how well an organisation uses its shareholders' equity to generate profits. It is a statistic that focuses on the company's internal efficiency, specifically in terms of equity capital.
• Rate of Return: This is a larger metric that analyses the profitability of an investment over a specific time period, independent of the type of investment. It might apply to any investment, including stocks, bonds, real estate, and other financial assets.

Knowing the differences between these two indicators allows you to make sound investment decisions regarding where and how to invest.

Formula to Calculate ROE

ROE can be calculated using only two components: net income and shareholders' equity. The ROE formula is as follows.

Return on Equity = (Net Income / Shareholders’ Equity) x 100

Source: Market Beat

Here, net income refers to a company's profit after deducting all expenditures, including taxes and interest. Shareholder equity, on the other hand, is the residual interest in the company's assets after deducting liabilities.

How to Calculate ROE? 

Let's look at a practical example of return on equity. Suppose LMN Ltd. has a net income of ₹ 4,00,000 and shareholders' equity of ₹ 6,00,000. Our method gives:

ROE = (₹ 4,00,000 / ₹ 6,00,000) x 100 = 66.67%

This outcome indicates that LMN Ltd. earns a 66.67% return on its shareholders' equity, which is pretty substantial.

To gain an accurate view of a company's success, use this calculation while keeping net income and equity values consistent throughout time. Using average equity determined over time, rather than a snapshot from a particular moment in time, can offer a more accurate picture.

What is an Ideal Return on Equity? 

Determining what makes a good ROE ratio may be tricky because it varies significantly among industries. In general, a ROE of 15% to 20% is considered good in many industries, while anything beyond 25% is regarded as outstanding.

However, a high ROE is not necessarily a good sign. For example, a company with diminishing equity but consistent net income may have a growing ROE, indicating underlying difficulties rather than robust profitability. A low ROE, on the other hand, does not always indicate challenges, it might simply indicate that the company is in a capital-intensive industry or is in a growth period, necessitating further reinvestment in the business.

How to Interpret ROE?

Interpreting ROE requires an extensive understanding of the components that influence both net income and shareholder equity. A constantly rising ROE is often a favourable indicator, showing that an organisation is getting more efficient at generating profits from its equity base. However, investors should be careful about companies that have an extremely high ROE, especially if it is due to diminished equity or greater leverage rather than improved company operations.

For example, if a corporation substantially increases its debt, it may reduce its equity (equity equals assets minus liabilities), thus inflating its ROE. Therefore, while assessing ROE, it is important to examine the company's debt levels, the consistency of equity, and the sustainability of net income growth.

Limitations Of ROE - Why is ROE considered an Imperfect Scale?

Despite its practicality, ROE has limits. Here are some reasons why ROE is seen as an imperfect assessment of a company's performance.

• Impact of Debt: Increasing debt can artificially enhance a company's ROE since it reduces equity while keeping net income constant. While this increases ROE, it does not always imply that the firm is doing well.
• Variability in Equity: Because ROE is based on shareholder equity, any change in equity, such as a share buyback or the issuance of additional shares, can dramatically tweak ROE without affecting the business's actual performance.
• Intangible Assets: ROE estimates often leave out intangible assets like patents, trademarks, or brand value, which can be crucial for some companies, particularly those in the technology or pharmaceutical sectors. This omission might result in an incorrect depiction of a company's actual performance.
• Manipulation by Management: In certain scenarios, management may alter ROE to paint a more favourable picture of the company's profitability. For example, lowering equity by buying back shares or raising debt might boost ROE without really improving operational efficiency.
• Short-term Focus: ROE is frequently more representative of short-term profitability and may not provide a complete view of the company's long-term growth prospects. Companies that prioritise long-term investments may have lower ROE in the short term, which can mislead investors.

Conclusion

Return on Equity is a key indicator that provides information about a company's efficiency in making profits from its shareholders' equity. However, while ROE is important, it should not be the only indicator used to guide investment decisions. Investors should combine ROE with other financial indicators and analysis to gain a complete picture of a company's financial health and performance. Understanding ROE, how it is calculated, and its limitations enables you to make better investment decisions. By carefully considering a company's ROE in context, you may better determine its profitability and prospects for growth.