The Complete Guide to ROE (Return on Equity)

Cheat Code Staff
return on equity sample equation
Image Credit: https://finexy.com/

If you want to start or invest in a company, you’ll want an effective and reliable way to calculate the company’s profitability. 

After all, is there a point in investing if there’s no chance of making a profit? 

To ensure your investments are worthwhile, you should calculate some business ratios, like ROE. 

Return on Equity helps investors measure the profitability of a particular business and is one of the essential metrics for companies to maximize profit. 

For instance, if your return on equity ratio is 120%, for every dollar you deposit, your business will earn $1.20. 

Basically, the higher your ROE, the more profit you gain from the company.

But what exactly is ROE? 

How does it work?

And is it that important? 

Read on to get the full rundown on our Guide to ROE:

What Is Return on Equity?

ROE, also known as Return on Net Assets, is a technique investors use to calculate the business’s financial performance. 

In particular, it’s your business’s profitability in regard to Equity

ROE helps investors select the best investment option by comparing one industry to another to determine which has a higher profitability rate.

An increased ROE means that the company effectively utilizes the investor’s Equity to increase income. 

But a low ROE indicates that your business is earning a lesser amount than the investor’s Equity. 

ROE is also an efficient way to estimate your company’s growth rate without requesting a loan.

Suppose you bought a pizza joint for around $100,000. 

If you earn an extra $5,000 each year after eliminating expenses, your ROE will be 5%

However, if you make at least $30,000 annually after eliminating costs, you have a better ROE.

How Do I Calculate ROE?

Calculating ROE is a pretty simple process. 

All you require to get accurate calculations is your business’s income statement and the balance sheet. 

The ROE is measured by dividing the net income by the average shareholder equity.

ROE = Net Income Average Shareholder Equity

So, you’ll first find your company’s net income for a particular period. 

Next, go to your balance sheet to calculate the shareholder’s Equity: this is the total assets minus total liabilities. 

Then divide the two as displayed in the above figure and get your ROE.

It is recommended to calculate your ROE based on your average Equity in a given period because of the inconsistency between your net income and balance sheet.

Analysis 

ROE calculates how effectively a company can use income attained from investors to maximize profit and boost the company. 

In contrast to most return-on-investment ratios, ROE mainly profits the investors or shareholders. 

In simpler terms, the ratio calculates the amount of money based on the shareholder’s investment in the business and not the company’s investments in resources or any aspect.

A good general principle is targeting an ROE equal to or slightly higher than the company’s competition. 

For instance, a company named TechCo Inc has sustained a steady ROE of 25% in the past several years compared to its competition, which has a 19% ROE

An investor will prefer TechCo’s management because it’s better at utilizing assets to maximize profits.

Significantly high or low ROE ratios will differ considerably between industries or sectors. 

Still, you can consider a short alternative near the long-term average of 19% as a sustainable ratio, but any ratio below 10% is poor.

ROE Across Industries

hand illustration with money on a circular motion
Image Credit: https://capital.com/

When comparing different ROEs across different companies, it’s essential you compare the figure with similar companies

This is because various industries usually have distinct ROEs. And an ROE that works well in one sector might be defective or poor in your industry.

To give an illustration; an investor wants to invest in a software company but has two companies to choose from. 

The first company is an entertainment software company with a 17% ROE while the second company is an internet software company with a 9% ROE. 

The investor might choose the first company based on the numbers because of a higher ROE. 

However, it’s crucial that the investor studies both industries and compare them to their competition. 

The second company’s ROE (9%) may be above the average in the internet software sector, while the first company’s ROE (17%) may be below the average in the entertainment sector.

An industry’s ROE can gradually change with time based on external aspects like competition. 

Based on the company, a negative ROE can result from one-time factors like restructurings, which reduce the net income, bringing about losses. 

Still, a company with a negative ROE isn’t necessarily a bad investment if the company is generating a generous free cash flow; or the cash that remains after all expenses are accounted for.

If you want to invest in the stock market, you should take a peek at some of the significant public industries to get a clear picture of a good ROE. 

For instance, according to a report by the FDIC, the weighted average ROE for the ten largest S&P 500 companies by market cap in 2017 was 18.6%. 

During that period, Apple Inc‘s ROE was 36.9%, and Facebook‘s ROE was 19.7%.

Final Thoughts 

quick formula in guide to roe

ROE is an essential aspect of any company if you want to invest your money correctly. 

Understanding the entire ROE concept and how to utilize it can help establish an effective investment strategy that will maximize profit. 

But before deciding where to invest, observe and study various companies and how each company is working to achieve a positive ROE and compare them to other sectors. 

With small observations and a bit of research, you can make the right moves and invest in an industry with a good ROE.

Visit our website to learn more about ROE or check out our other blogs.

TAGGED: ,
Share This Article
Leave a comment