ROE, return on equity, is an important measure of a company's profitability and growth potential. Investors, analysts and shareholders use it to evaluate the profit performance of a business and its potential to grow in the future. However, ROE has limitations in its reliability as a completely accurate indicator of the profit performance and financial health of a company. A more detailed investigation of a company's ROE is required to get a thorough understanding of a firm's performance.
What Is Return on Equity?
ROE is a measure of how much profit a company can produce from its assets. In this sense, it is a gauge of the effectiveness of management in using the company's assets to generate the most earnings. Companies with high ROEs have a competitive advantage, generate the most cash flow, grow steadily and are more attractive to investors.
Formula for ROE
Return on equity is calculated by dividing a company's after-tax net income by the total amount of shareholders' equity as follows:
Net Income/Shareholders' Equity = Return on Equity
For the purpose of this calculation, net income is after payment of dividends to preferred stock but before dividends due to common stockholders. Shareholders' equity is only the amount of common stock; preferred stock is not included.
Significance of Return on Equity
ROEs are useful for comparing the performance of companies within the same industry. They show which companies are doing better or worse compared to their competitors. ROEs are not helpful in comparing one company to another company in a different industry.
Why Is ROE Important?
Businesses with a high return on equity and minimal debt have ample cash to expand their operations and grow their earnings. They can grow the businesses without taking on additional debt or seeking more outside capital. Companies with high ROEs will have higher growth rates.
A company cannot grow its profits faster than its ROE without raising additional funds by borrowing more money or selling more shares. However, taking on more debt increases interest costs, which reduces net income; selling more common stock increases the number of outstanding shares and reduces earnings per share. A declining ROE is a red flag and could be a sign of financial missteps or poor management of the company's assets.
Problems With Interpreting ROE
ROE is not a perfect indicator of a company's performance. It serves as a starting point, but further analysis must be done to determine the integrity of this metric.
For example, while a high ROE is attractive, it doesn't say anything about the amount of debt a company has on its balance sheet. A company with higher debt levels compared to others in the industry will be able to generate a higher ROE than its rivals. The downside is that high debt means higher risk because of the increase in fixed costs of interest payments and amortization of principal. The company is less able to weather downturns in profit margins or increases in interest rates.
A company can increase its ROE by buying back its own stock. Stock repurchases reduce the amount of common equity in the firm, and, if profits remain the same, the ROE will go up. Management did not suddenly become more efficient; it just reduced the denominator of the ROE calculation.
Write-downs are accounting entries that can reduce shareholder equity and artificially increase ROE in subsequent years after the one-time charge to income. A write-down is the reduction in the book value of an asset that has become overvalued in the market. It is a paper entry and does not signify that the company has improved the efficiency of its operations.
ROE is a valuable tool used to evaluate the performance of a company. It is most useful when comparing the performance of one company to others in the same industry. However, ROE should be considered in the context of a company's debt structure, changes in equity capital and any accounting adjustments that are not part of operations.
James Woodruff has been a management consultant to more than 1,000 small businesses. As a senior management consultant and owner, he used his technical expertise to conduct an analysis of a company's operational, financial and business management issues. James has been writing business and finance related topics for National Funding, PocketSense, Bizfluent.com, FastCapital360, Kapitus, Smallbusiness.chron.com and e-commerce websites since 2007. He graduated from Georgia Tech with a Bachelor of Mechanical Engineering and received an MBA from Columbia University.