What Is Return on Equity?

For investors, one of the most common first steps of fundamental analysis is looking at profitability ratios. This key financial metric measures a company’s ability to generate earnings relative to its expenses and other costs. Of course, you’ll also look at other ratios and metrics to make sure you get the big picture before investing.

But without profitability ratios like net profit margin, operating profit margin or return on equity, investors can’t truly know if a company has been or will remain profitable enough to invest in.

Two well-known profitability ratios are return on equity (ROE) and return on assets (ROA). Both gauge a company’s ability to generate earnings from their investments, but they don’t exactly represent the same thing. In this article we go over a few key concepts: how to calculate return on equity, what this common metric entails and how to use it effectively before investing.

What Is Return on Equity?

Return on equity measures how much net income was earned as a percentage of shareholder’s equity. Put simply, it shows how much profit a company generates with the money shareholders have invested.

How to Calculate ROE

Calculating ROE is simple. Take a company’s net income and divide that number by its shareholder’s equity. Shareholder’s equity includes assets but not liabilities.

Although ROE can be calculated as noted above, it is useful to break it down into several components that are key to a firm’s ROE: profitability, efficiency and financial leverage. This relationship can be stated in a formula as follows:

ROE = Net profit margin × Asset turnover × Equity multiplier

Now, let’s get into these three main components.

• Net profit margin: Calculated by dividing net income by sales. This gives potential investors a representation of a company’s pricing strategy, which depends on several key factors. Companies aim to find the optimal price point for their products and services that will maximize their total profits while generating stable sales growth.
• Asset turnover: Measured by dividing sales by total assets. This ratio measures how efficiently a company uses its asset base to generate sales. It’s important to remember that most higher-margin companies can generate the same absolute dollar of earnings with lower sales volume.
• Equity multiplier: Calculated by dividing total assets by shareholder’s equity. This ratio measures the amount of debt a firm uses, or its financial leverage. Assets are equal to liabilities plus shareholder’s equity; therefore, the higher the ratio, the more debt the company employs in relation to shareholder’s equity. This is important because companies can fund additional projects using debt instead of additional equity. Therefore, a company can boost its return on equity by taking on more debt or liabilities.

These three components allow investors to analyze the actual drivers behind a company’s return on equity. Using this formula when evaluating a company, investors can understand if a company has been able to effectively use debt to drive stronger profits as well as how margins and asset turnover are trending over time.

If you’re interested in learning more about these three key components, check out our explanation and background of the DuPont formula used to calculate ROE.

Where to Find Data to Calculate ROE

You can find return on equity on the AAII website. If you want quick access to a company’s ROE, you can easily type in any stock ticker to the search bar on the AAII website and scroll down the Snapshot tab. Under Financial Summary, the Ratios section shows stock’s current ROE with two comparison statistics: how its ROE ranks among all stocks, and the median ROE for the industry that the company is in. Net income is also reported on this page, in the Financials section.

AAII’s A+ investors can access the Ratios tab for a stock to see return on equity data for the trailing 12 months and the last seven fiscal years. It also shows the median industry ROE over these periods for comparison.

What Does Return on Equity Tell Investors?

Investors can use return on equity to measure the earnings a company generates from its assets. With return on equity, you can easily determine whether a firm is a profit-creator or a profit-burner and management’s profit-generating efficiency. Shareholders care because they are looking for companies that can generate investment returns. Companies that are good at coaxing profits from their operations tend to have competitive advantages and may be good additions to investors’ portfolios.

Additionally, return on equity indicates how much the stockholders earned for each dollar they have invested in the company. However, the level of debt (financial leverage) on the balance sheet has a large impact on this ratio. Debt magnifies the impact of earnings on return on equity during both good and bad years. When large differences between return on total assets and return on equity exist, you should closely examine the amount of debt the firm has employed.

In general, analyzing profitability ratios like return on equity allows investors to:

• Measure the return a company is generating from its line of business, how it finances its business, and its tax structure—using profit margin ratios.
• Evaluate the return a corporation is generating from its own assets—by determining return on total assets.
• Analyze the return shareholders are getting from their invested dollars—with return on shareholder’s equity, also known as book value, which is the difference between total assets and total liabilities.

It is best to look at return on equity and return on assets together. While they are different figures, when used in tandem they offer a clearer picture of management effectiveness. When ROA is solid and the company is carrying a reasonable amount of debt, a strong ROE is signals that management is doing a good job of generating returns from shareholders’ investment. However, if ROA is low and the company is overburdened with debt, a high ROE can mislead investors into thinking things are better than they actually are.

ROE Limitations

Even though investors can utilize return on equity to effectively evaluate a company, there are always limitations when it comes to any financial metric. Relying on the formula derive return on equity tells an incomplete story about a company. For example, a company can boost its return on equity by taking on additional debt. If its debt load becomes excessive, it may force the company into bankruptcy. As a result, it is a good idea to examine the drivers of ROE as well as other profitability metrics.

As we mentioned, a high return on equity might not always be positive and can be caused by taking on too much debt, while a negative return on equity can be caused by the company having a net loss or negative shareholder’s equity.

Key Differences Between Return on Equity and Return on Invested Capital

Every investor is different, that’s why it’s important to find a profitability ratio that works with your own individual goals. Even though return on equity indicates to investors how much profit a company can generate relative to shareholder’s equity, return on invested capital (ROIC) gives a more complete calculation and understanding. Return on invested capital takes a company’s dividends into account as well as additional revenue based on all its sources of capital, including shareholder’s debt and equity.

Return on invested capital and return on assets can be used together to fill the gaps that return on equity leaves. It’s important to remember that relying solely on return on equity, or any one ratio, can be risky since each ratio has its limitations.

How to Use ROE When Investing

It pays to invest in companies that generate profits more efficiently than their competitors. Return on equity is one financial metric that can be used to judge a company’s effectiveness at translating investor equity into profits.

Because a rising return on equity can indicate that a company is able to grow profits without adding new equity into the business, potential investors can weed out companies that may dilute the ownership share of existing shareholders. The higher a company’s return on equity, the better management is at employing investors’ capital to generate profits.

A company cannot grow earnings faster than its current return on equity without raising additional cash. Companies raise cash by either selling new shares or by issuing debt. However, there are costs associated with both activities: Issuing debt leads to interest expense, which can lower net income; and selling more shares lowers earnings per share by increasing the number of outstanding shares.

That’s why it’s always important to use multiple financial metrics to evaluate a company before investing. Learn how you can utilize A+ Investor’s financial ratio analysis and stock screening tools to conveniently find potential investment opportunities. Subscribe today and starting using A+ Investor’s robust suite of tools and resources.