Return on equity (ROE) and return on assets (ROA) determine how efficient a company can be at generating profits. Both formulas that can help investors determine how good a company is at turning a profit. Let’s take a look at both metrics, how to use them, how they differ and what their limitations are.
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Return on Equity Definition
According to the Corporate Finance Institute, return on equity (ROE) is a percentage that expresses a company’s annual income relative to its total shareholder equity. The equation for ROE is the company’s net income for the year divided by its shareholders’ equity. ROE is a great way to calculate a company’s profitability—put simply, how good it is at making money.
A company’s net income is the amount of money it brings in after paying all its financial obligations, such as taxes and operating expenses. Shareholder equity is the sum of a company’s net worth. The idea is that if the company shut down and liquidated its assets and paid off its debts immediately, the shareholder equity would be the remaining amount that would be distributed to those who owned stock in that company.
Here’s a simplistic example to illustrate how ROE works: Let’s say Company A has a net income of $10 million. Meanwhile, their total stockholder equity—the amount the company would pay to stockholders if it liquidated all its assets and paid off its debts—is $80 million. The ROE for Company A would be 12.5%.
Thus, ROE can be a valuable metric to use as an investor. If you’re considering investing in a company, you can look at their ROE over the years to see if its growing or diminishing, which can point to whether leadership is making wise decisions that benefit shareholders. You can also compare that company’s ROE to other companies in the sector to see how their financial performance matches up.
Return on Assets Definition
Return on assets (ROA) is a different equation but serves a similar purpose: determining how effective a company is at utilizing their assets to create more value. The equation used for ROA is taking the company’s net income and dividing it by their total assets.
A company’s total assets include everything that company owns that can generate money. That might be plain old cash, inventory, intellectual property such as patents, real estate and more. If they could sell it for a profit, that’s an asset.
Let’s take a look at what a simple example of ROA might look like. Let’s say Company B has a net income of $5 million and owns $25 million in assets. When you do the math, you see that Company B has an ROA of 20%. That means for every dollar of assets, the company generates 20 cents in profit.
ROA can be helpful because it shows how a company is using its current investments to generate profits. Higher percentages mean the company is better at its assets to make more money; lower percentages mean that its worse at it.
How ROE and ROA Differ
If both of these measurements sound pretty similar to you, you’re not wrong. They do have a lot in common — both in what they measure and the purpose they serve. But they do have some important differences.
The single biggest difference between ROA and ROE is that ROA takes into account a company’s debt, while ROE doesn’t. If a company doesn’t have any debt, these two numbers would be the same for that company. Debt can add new assets to a company’s balance sheet, but of course the company also now has a financial obligation to its creditor.
Companies can use debt to artificially boost their ROE. Companies can generate profits by borrowing large amounts of money and using that to drive greater income. Of course, that money isn’t free and a company with too much debt isn’t healthy. Make sure you examine both of these metrics rather than just relying on ROE.
How to Use These Metrics
It’s important to know that there are some limitations to these metrics. Investors should not make decisions based on any one number. Any one number may not be representative of the company as a whole, and there are many ways that numbers can be manipulated by unethical accounting methods.
ROE particularly can be manipulated due to the fact it’s not impacted by how a company is leveraged—that is, how much debt it has. As mentioned above, company can borrow extensively to boost profits and artificially inflate their ROE. Stock buybacks can have a similar effect. Make sure that you’re taking a look at the company’s entire balance sheet and wider strategy before making any investment decisions.
And you may be asking: How will I know whether a certain percentage is “good?” For ROA, over 5% is good and over 20% is great. For ROE, 15-20% is considered good — in 2022, S&P 500 companies averaged a ROE of just over 21%. However, these standards can differ greatly between sectors and industries.
The Bottom Line
ROE and ROA can both extremely useful metrics for investors determining the financial health of a company. These formulas can help you determine whether a company is using their assets in a productive and efficient way—and thus, whether or not you should invest in them.
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