What is Return on equity (ROE) - Formula & Calculation

When it comes to trading in stocks or investing in mutual funds, there are several metrics that need to be considered. Each of them highlights the performance of the company and when considered together gives a picture of its financial health. One such metric is Return on Equity, also known as ROE. Let’s find out more about it and how you can use it to make smart investment decisions.  

What is Return on Equity (ROE)? 

Return on Equity (ROE) is a vital financial metric that measures how efficiently a company utilises shareholders' equity to generate profit. It provides investors with insights into the profitability and operational efficiency of a business, making it a crucial tool for evaluating company performance. 

ROE is expressed as a percentage and helps in comparing firms within the same industry. A higher ROE generally signals that a company is effectively using its equity base to maximise returns for its shareholders. 

For example, if a company achieves an ROE of 20%, it means it generates ₹ 20 in net income for every ₹ 100 of equity invested by shareholders. This metric is especially valuable for equity investors seeking stable, high-performing companies. 

What is the Importance of ROE? 

ROE serves as an indicator of profitability and efficiency. Here’s why it’s significant: 

1. Measures Profitability: ROE highlights how much profit a company generates relative to its equity base. Investors often favour companies with higher ROE as they indicate better returns on their investments. 

2. Indicator of Management Efficiency: It reflects the ability of the company’s management to use equity capital effectively. Higher ROE typically points to competent management. 

3. Investor Decision-Making: By comparing ROE across companies, investors can identify high-performing businesses and avoid underperformers. 

4. Evaluation of Business Growth: Companies with consistently high ROE may have better growth potential, as they are reinvesting earnings efficiently. 

Difference Between Rate of Return and Return on Equity 

While both metrics measure returns, they focus on different aspects: 

• Rate of Return: Reflects the overall return on an investment, including both equity and debt financing. It considers the total capital employed. 

• Return on Equity: Focuses exclusively on shareholders' equity, offering a more targeted view of returns for equity investors. 

For example: 

• A company with ₹ 500,000 in total investment (debt and equity) and ₹ 50,000 in profit has a 10% Rate of Return. 

• If ₹ 300,000 is equity and ₹ 50,000 profit, ROE becomes approximately 16.67%. 

Return on Equity Formula 

The formula for return on equity calculation is: 

ROE = Net Income ÷ Shareholders' Equity 

• Net Income: The profit a company earns after taxes and expenses. 

• Shareholders' Equity: The difference between total assets and total liabilities, representing the net worth of the company.  

For example: 

If a company earns ₹ 1,00,000 in net income and has ₹ 5,00,000 in shareholders' equity, the ROE calculation is: 

ROE = ₹ 1,00,000 ÷ ₹ 5,00,000 = 20%. 

How to Calculate ROE? 

To perform an ROE calculation, follow these steps: 

• Obtain Net Income: Find the company’s net income as declared in its income statement. 

• Determine Shareholders' Equity: Refer to the balance sheet for total cumulative equity figures. 

• Apply the ROE Formula: Divide the net income by shareholders' equity and multiply by 100 to get a percentage. 

For instance, if a company reports ₹ 8,00,000 as net income and ₹ 80,00,000 as equity: 

ROE = (₹ 8,00,000 ÷ ₹ 80,00,000) × 100 = 10%. 

What is an Ideal Return on Equity (ROE)? 

There isn’t a universal benchmark for a "good" return on equity (ROE). What’s considered a strong ROE can vary significantly across industries. While some sectors such as technology or service industries may view an ROE above 25% as ideal, other industries with high competition and capital intensity may have lower average ROE where a figure of over 15% can be considered quite good. It’s also important to note that a lower ROE doesn’t always signal trouble for a company. In certain situations, an ROE may dip for a year due to various factors. 

For example, a company might have recently invested in new equipment after receiving fresh capital, causing a temporary dip in ROE. Therefore, investors should focus on the long-term ROE to get an accurate picture of the company’s performance. 

In some cases, a high ROE may not always indicate positive growth. Here are a few scenarios where this could be the case: 

A decline in the company’s equity investment: If a company’s equity investment falls, it can result in a higher ROE, but this doesn’t necessarily mean better profitability. For example, consider a company (Company X) that made a net income of ₹0.60 crore in 2018, with shareholders’ equity of ₹4 crore. The ROE would be 15%. However, if the equity drops to ₹2 crore the next year while the net income remains the same, the ROE would rise to 30%. A drop in equity indicates the company is facing financial challenges. 

An increase in the company’s debt: Similarly, when a company takes on excessive debt, the ROE may spike temporarily, but this is a red flag. While the company may appear more profitable in the short term, high levels of debt can lead to serious risks down the line. A new business may also show a negative ROE initially, but that doesn’t necessarily reflect poor management; it might just be in the process of becoming profitable.  

Therefore, relying solely on ROE to assess a company’s potential can be misleading. Ideally, you should use a broader range of financial indicators to make more informed decisions. 

How to Interpret ROE? 

ROE interpretations depend on context and the industry norms. They should not be taken in isolation, as the sole yardstick of performance measurement. However, in general, here are some ways to intercept ROE: 

• High ROE: Often signifies strong profitability and efficient equity use. For instance, an ROE of 25% in the tech sector indicates robust earnings relative to equity. 

• Low ROE: May indicate inefficiencies, excessive debt, or operational challenges. For example, a 5% ROE in manufacturing might signal underperformance. 

• Negative ROE: Indicates losses, where liabilities exceed equity, signaling poor financial health. 

Limitations of ROE 

Despite its usefulness, ROE has limitations: 

1. Debt Dependency: A company with excessive debt can show artificially high ROE, as equity decreases. Investors should check the debt-to-equity ratio alongside ROE. 

2. Sector Variability: ROE norms differ across industries, making cross-sector comparisons unreliable. 

3. Short-Term Focus: ROE might overlook long-term growth potential if companies prioritise short-term profit boosts. 

Due to these limitations, it is important to use ROE along with other financial metrics to conduct a holistic analysis of the company and its performance, before making an investment decision. 

In Summation 

Return on Equity (ROE) is a useful financial tool that provides valuable insights into a company’s profitability and efficiency in using shareholders' equity. By understanding the return on equity formula and performing an ROE calculation, you can make informed decisions about your portfolios. However, it’s essential to interpret ROE in context, considering industry norms and the company’s overall financial health. When used alongside other metrics, ROE becomes an indispensable tool for evaluating investments.