Return on equity (ROE) measures how well a company generates profits for its owners. It is defined as the business’ net income relative to the value of its shareholders’ equity. It reveals the company’s efficiency at turning shareholder investments into profits. Since ROE takes the net income from a business’ income statement and the shareholders’ equity from its balance sheet, it can be seen as the amount that would be left over for shareholders if the company liquidated its assets and paid off its debts.
ROE helps investors choose investments and can be used to compare one company to another to suggest which might be a better investment. Comparing a company’s ROE to an average for similar companies shows how it stacks up against peers. Here’s how ROE is calculated, plus how you can use it to analyze your potential investments.
How to Calculate a Company’s Return on Equity
Sometimes ROE figures are compared at different points in time. This can show whether a company’s management is making good decisions in order to generate income for shareholders. Declining ROE suggests the company is becoming less efficient at creating profits and increasing shareholder value.
To calculate the ROE, divide a company’s net income by its shareholder equity. Here’s a look at the formula:
- ROE = Net Income / Shareholder Equity
The result of this equation is then usually expressed as a percentage or ratio.
For example, let’s say a company has $1.2 million in net income, $200,000 in preferred dividends and $10 million in shareholder equity. First, we’ll subtract the preferred dividends from the net income:
- $1.2 million – $200,000 = $1 million
Then we’ll divide that net income by shareholder equity:
- $1 million / $10 million = 10%
This equals a ROE of 10%. This result shows that for every $1 of common shareholder equity the company generates $10 of net income, or that shareholders could see a 10% return on their investment.
As a general rule, the net income and equity must be positive numbers in order to demonstrate ROE. Additionally, a higher ROE is better. Lastly, the best way to calculate ROE is to use the average of the beginning and ending equity for common stockholders with preferred dividends not included. The result could tell investors to consider a company with a higher ROE a better investment than similar organizations.
What ROE Really Means
A company’s management can use ROE internally to determine if they’re making good decisions that efficiently generate profits. When used for this purpose, ROE may be calculated annually or quarterly, and then compared over a span of five or 10 years.
While the general rule is that a higher ROE is better, it’s worth noting that it does not necessarily mean more profits for shareholders. Holders of preferred dividend-paying shares may see higher dividend payouts if ROE is rising. However, common stockholders only benefit financially if profits are retained and the stock price rises.
Also, high ROE doesn’t always mean management is efficiently generating profits. In addition to changes in net income, ROE can also be affected by the amount that a company borrows. Increasing debt levels can cause ROE to grow even when management is not necessarily getting better at generating profit. Share buybacks and asset write-downs may also cause ROE to rise when the company’s profit is declining.
ROE Across Industries
When comparing one company’s ROE to another, it’s important to compare figures for similar firms. That’s because different industries tend to have different ROEs. And what looks like a good ROE in one sector may be a weak ROE in another.
For example, let’s say an investor is looking to invest in one of two software companies. Company A is an entertainment software company with an ROE of 13%. Company B is an internet software company with an ROE of 6%. At first glance, the investor may decide to choose company A for its higher ROE. However, it’s important that the investor look more closely at the specific sectors of the software industry. Company B’s ROE may actually be higher than average for the internet software sector, while company A’s ROE may actually be below the entertainment software sector’s average.
A 2019 analysis of more than 6,000 firms across more than 100 industries found ROE averaged about 15.6%. The highest ROE in this study belonged to building supply retailers, which boasted an average ROE of nearly 96%. Other high ROEs were seen in broadcasting companies (82%) and railroad transportation companies (52%). Low ROEs in this study belonged to consumer and office electronics firms, which showed a -33% ROE. Precious metals and tobacco were also low, with both ROEs close to -3%.
An industry’s average ROE can change over time depending on external factors such as competition. On a company basis, a negative ROE may be caused by one-time factors such as restructurings that depress net income and produce net losses. A company or an industry with negative ROE can still be a good investment if business operations are producing generous free cash flow, or money that’s left over after a company pays for its operating expenses and capital expenditures.
If you’re considering investing in the stock market, a look at the average ROE for some of the largest public companies could also help you understand what a good ROE looks like. For example, a report by the FDIC found that the weighted average ROE for the 10 largest S&P 500 companies by market cap in 2017 was 18.6%. At the time, Apple Inc. had an ROE of 36.9% while Facebook Inc. had an ROE of 19.7%.
Other Key Metrics
ROE is one of many numbers investors and managers use to measure return and support decision-making. Return on investment (ROI), for instance, is a similar figure that divides net income by investment. However, unlike ROE, ROI does not include debt.
ROI helps show a company’s return on investor money before the effects of any borrowing. If ROE is positive while ROI is negative, the company could be using borrowed money instead of internally generated profits to survive.
Return on capital (ROC) is another ratio commonly used to analyze companies. The formula for this varies, but one version divides net after-tax operating profit by invested capital. Using after-tax operating profit instead of net income removes any gains from selling assets or interest on loans.
The figure for capital in ROC is represented by book value of the owners’ equity. That includes debt but not cash. By leaving out non-operating income and cash assets, ROC reveals how much profit is being generated by the business operations.
The Bottom Line
ROE can help investors make smart decisions with their money. Understanding what ROE means and how to use it when comparing companies can help you craft a smart investment strategy. Be mindful of how companies are working to achieve their positive ROE and aim to compare companies within the same industry and sector before deciding where to invest your money. With a little research, you’ll be able to make smart money moves and invest in a company with a good ROE.
Tips For Investors
- If you’re still unsure where to invest your money, consider working with a financial advisor. Finding the right financial advisor that fits your investment needs doesn’t have to be hard. SmartAsset’s free tool matches you with financial advisors in your area in five minutes. If you’re ready to be matched with local advisors that will help you achieve your financial goals, get started now.
- Investing money in the stock market could help your money grow significantly over time. Stocks come with the power of compound interest and with the right strategy you could see a large return on your investment. If you’re ready to invest in stocks on your own, consider an online brokerage or robo-advisor.
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