Return on equity (ROE) is a key indicator of how well a company is doing financially. You get it by dividing the net income by the shareholders’ equity. Since shareholders’ equity is basically the company’s assets minus its debts, ROE gives you a snapshot of how well a company is using its net assets to generate returns.
ROE is often seen as a measure of a company’s profitability and its efficiency in making money. A higher ROE means that the company’s management is doing a great job at turning equity financing into income and growth.
How Return on Equity Works
ROE, or Return on Equity, is shown as a percentage and can be figured out for any company as long as both net income and equity are positive. To calculate net income, you take the earnings before paying dividends to common shareholders, but after paying dividends to preferred shareholders and interest to lenders.
Whether an ROE is considered good or bad really depends on what’s typical for similar companies in the same industry. For instance, utility companies usually have a lot of assets and debt, which means their net income is relatively low. So, a normal ROE in that sector might be around 10% or even less. On the flip side, tech or retail companies, which often have smaller balance sheets compared to their net income, might see normal ROE figures of 18% or higher.
A solid guideline is to aim for an ROE that’s at least equal to or slightly above the average for the sector. For example, if a company called TechCo has consistently achieved an ROE of 18% over the years, while its peers average around 15%, it suggests that TechCo’s management is doing a better job at turning assets into profits.
ROE ratios can differ a lot between industries. A quick rule for investors is to view anything below 10% as a weak return on equity, while anything close to the long-term average of the S&P 500 is seen as acceptable. As of the second quarter of 2024, that acceptable ROE would be around 21.71% or higher.
Calculation for Return on equity
Calculating ROE using the average equity over a certain time frame is generally seen as the way to go. This is mainly due to the differences that can pop up between the income statement and the balance sheet. ROE measures how much net income is generated in relation to shareholder equity. The formula looks like this:
ROE = ( Net Income / Shareholders’ Equity )Conclusion
Return on equity (ROE) is a popular financial measure that looks at how much profit a company makes compared to its total shareholders’ equity. It gives a good idea of how profitable and efficient a company is. Another handy metric is the return on average equity (ROAE).
That said, while ROE and ROAE can show how effectively a company is turning resources into profit, they don’t give a complete view of the company’s financial setup, the industry it’s in, or how it stacks up against competitors. ROE is just one of many tools investors can use to assess a company’s performance, growth potential, and overall financial health.