how return on equity works
roe is expressed as a percentage and can be calculated for any company if net income and equity are both positive numbers net income is calculated before dividends paid to common shareholders and after dividends to preferred shareholders and interest to lenders whether an roe is deemed good or bad will depend on what is normal among a stock s peers for example utilities have many assets and debt on the balance sheet compared to a relatively small amount of net income a normal roe in the utility sector could be 10 or less a technology or retail firm with smaller balance sheet accounts relative to net income may have normal roe levels of 18 or more a good rule of thumb is to target a return on equity that is equal to or just above the average for the company s sector those in the same business for example assume a company techco has maintained a steady roe of 18 over the past few years compared to the average of its peers which was 15 an investor could conclude that techco s management is above average at using the company s assets to create profits relatively high or low roe ratios will vary significantly from one industry group or sector to another however a common shortcut for investors is to consider anything less than 10 a poor return on equity and anything near the long term average of the s p 500 acceptable as of the second quarter of 2024 this means an acceptable roe would be around or above 21 71 2calculating return on equity roe it is considered best practice to calculate roe based on average equity over a period because of the mismatch between the income statement and the balance sheet roe is calculated by comparing the proportion of net income against the amount of shareholder equity the equation is roe net income shareholders equity begin aligned textbf roe frac textbf net income textbf shareholders equity end aligned roe shareholders equitynet income net income is calculated as the difference between net revenue and all expenses including interest and taxes it is the most conservative measurement for a company to analyze as it deducts more expenses than other profitability measurements such as gross income or operating income average shareholders equity is calculated by adding equity at the beginning of the period the beginning and end of the period should coincide with the period during which the net income is earned net income over the last full fiscal year or trailing 12 months is found on the income statement a sum of financial activity over that period shareholders equity comes from the balance sheet a running balance of a company s entire history of changes in assets and liabilities 1because net income is earned over a period of time and shareholders equity is a balance sheet account often reporting on a single specific period an analyst should take an average equity balance this is often done by taking the average between the beginning balance and ending balance of equity using return on equity to evaluate stock performancereturn on equity can be used to estimate different growth rates of a stock that an investor is considering assuming that the ratio is roughly in line or just above its peer group average investors can use roe to estimate a stock s growth rate and the growth rate of its dividends these two calculations are functions of each other and can be used to make an easier comparison between similar companies to estimate a company s future growth rate multiply the roe by the company s retention ratio the retention ratio is the percentage of net income that is retained or reinvested by the company to fund future growth 3assume that there are two companies with identical roes and net income but different retention ratios this means they will each have a different sustainable growth rate sgr the sgr is the rate a company can grow without having to borrow money to finance that growth the formula for calculating sgr is roe times the retention ratio or roe times one minus the payout ratio 4for example company a has an roe of 15 and has a retention ratio of 70 for company a the sustainable growth rate is company b also has an roe of 15 but has a 90 retention ratio company b s sustainable growth rate is a stock that is growing at a slower rate than its sustainable rate could be undervalued or the market may be accounting for key risks in either case a growth rate that is far above or below the sustainable rate warrants additional investigation using return on equity to identify risksa strong return on equity is a positive thing for a company an extremely high roe can be a good thing if net income is extremely large compared to equity because a company s performance is so strong however an extremely high roe can also be the result of a small equity account compared to net income which indicates risk an outsize roe can be indicative of a number of issues such as inconsistent profits or excessive debt in general both negative and extremely high roe levels should be considered a warning sign worth investigating a return on equity that widely changes from one period to the next may also be an indicator of inconsistent use of accounting methods the first potential issue with a high roe could be inconsistent profits imagine that a company lossco has been unprofitable for several years each year s losses are recorded on the balance sheet in the equity portion as a retained loss these losses are a negative value and reduce shareholders equity now assume that lossco has had a windfall in the most recent year and has returned to profitability the denominator in the roe calculation is now very small after many years of losses which makes its roe misleadingly high a second issue that could cause a high roe is excess debt if a company has been borrowing aggressively it can increase roe because equity is equal to assets minus debt the more debt a company has the lower its equity can fall a common scenario is when a company borrows large amounts of debt to buy back its own stock this can inflate earnings per share eps but it does not affect actual performance or growth rates 5finally negative net income and negative shareholders equity can create an artificially high roe however if a company has a net loss or negative shareholders equity roe should not be calculated if shareholders equity is negative the most common issue is excessive debt or inconsistent profitability however there are exceptions to that rule for companies that are profitable and have been using cash flow to buy back their own shares for many companies this is an alternative to paying dividends and it can eventually reduce equity buybacks are subtracted from equity enough to turn the calculation negative in rare cases a negative roe ratio could be due to a cash flow supported share buyback program and excellent management but this is the less likely outcome in any case a company with a negative roe cannot be evaluated against other stocks with positive roe ratios it is generally less risky to consider a stock with an average or slightly above the average roe when compared to its peer companies rather than one that is double triple or even higher than its industry average limitations of return on equitythere are times when return on equity can t be used to evaluate a company s performance or profitability a negative roe due to the company having a net loss or negative shareholders equity cannot be used to analyze the company nor can it be used to compare against companies with a positive roe the term roe is a misnomer in this situation as there is no return the more appropriate classification is to consider what the loss is on equity roe often can t be used to compare different companies in differing industries roe varies across sectors especially as companies have different operating margins and financing structures in addition larger companies with greater efficiency may not be comparable to younger firms roe is just one of many metrics for evaluating a firm s overall financials investors should utilize a combination of metrics to get a full understanding of a company s financial health before investing return on equity vs return on invested capitalthough roe looks at how much profit a company can generate relative to shareholders equity return on invested capital roic takes that calculation a couple of steps further the purpose of roic is to figure out the amount of money after dividends a company makes based on all its sources of capital which includes shareholders equity and debt roe looks at how well a company uses shareholders equity while roic is meant to determine how well a company uses all its available capital to make money 6you can calculate a company s return on equity using microsoft excel return on equity and dupont analysisthough roe can easily be computed by dividing net income by shareholders equity a technique called dupont decomposition can break down the roe calculation into additional steps created by the american chemicals corporation dupont in the 1920s this analysis reveals which factors are contributing the most or the least to a firm s roe there are two versions of dupont analysis the first involves three steps roe npm asset turnover equity multiplier where npm net profit margin the measure of operating efficiency asset turnover measure of asset use efficiency equity multiplier measure of financial leverage begin aligned text roe text npm times text asset turnover times text equity multiplier textbf where text npm text net profit margin the measure of operating text efficiency text asset turnover text measure of asset use efficiency text equity multiplier text measure of financial leverage end aligned roe npm asset turnover equity multiplierwhere npm net profit margin the measure of operatingefficiencyasset turnover measure of asset use efficiencyequity multiplier measure of financial leverage alternatively the five step version is as follows roe ebt s s a a e 1 tr where ebt earnings before tax s sales a assets e equity tr tax rate begin aligned text roe frac text ebt text s times frac text s text a times frac text a text e times 1 text tr textbf where text ebt text earnings before tax text s text sales text a text assets text e text equity text tr text tax rate end aligned roe sebt as ea 1 tr where ebt earnings before taxs salesa assetse equitytr tax rate both the three and five step equations provide a deeper understanding of a company s roe by examining what is changing in a company rather than looking at one simple ratio as always with financial statement ratios they should be examined against the company s history and its competitors histories for example when looking at two peer companies one may have a lower roe with the five step equation you can see whether this is because identifying sources like these leads to a better knowledge of the company and how it should be valued 