Return On Equity: What is its significance and how to calculate it

Return on equity (ROE) is a metric for evaluating a company's financial performance. It demonstrates the connection between earnings and investor returns. Thus, a company's ROE demonstrates how much profit it makes with shareholders’ equity. Also, it tells how well its management team uses that money to grow the business and benefit the investors and the company. The more effectively the company's operations use those funds, the better the ROE.

ROE is the total return on equity capital that displays the firm's capacity to convert equity investments into profits. Additionally, it assesses how profitable a business is compared to its rivals. 

Investors can see the company's growth history by averaging ROE over a period, such as 5 or 10 years. Companies having a competitive edge and the capacity to create shareholder value can be identified by comparing five-year average ROEs.

Return on Equity formula

Let’s learn about the return on equity ratio formula: 

We divide a company's net income by shareholder equity to determine its ROE. The result is expressed in ratio or percentage. Look at the following ROE formula to understand the calculation:

ROE = Net Income / Shareholder Equity

ROE offers a straightforward tool for assessing investment returns. A company's competitive advantage is identified by comparing its ROE with the industry average. ROE also shows how the company’s management is utilizing equity capital to expand the company. A firm that can sustain and grow its ROE over time is good at creating shareholder value. This is because it understands how to reinvest its earnings to boost productivity and profits. A diminishing ROE indicates that the management is spending money on underperforming assets.

Also read about Share Capital of the company.

How to calculate ROE -- with examples

Having understood the return on equity formula, let’s see how to use it in calculations. We will use two ROE examples in this section. So, let's start and look at some instances of using the return on equity calculator. 

Example 1

Consider a corporation with Rs 10 million in shareholder equity, Rs 200,000 in preferred dividends, and Rs 1.2 million in net income. According to the return on equity formula, we'll start by deducting the preferred dividends from net income, which is Rs 1 million.

Once that net income has been divided by shareholder equity:

Rs 1,000,000 / Rs 10,000,000 = 10%

This results in a 10% ROE. It demonstrates the corporation generates Rs 10 in net income for every Rs 1 of common shareholder ownership. Thus, investors receive a 10% return on their investment.

Example 2

Let's examine two businesses, A and B. The ROE for both of these businesses, which are both in the apparel sector, is 45%. Let's now examine and assess each of the businesses.

The profit margin for Firm A is relatively high at 40%. The financial leverage is likewise very good (4.0). However, it is substantially smaller when we consider the entire asset turnover. This implies that Firm A cannot utilize its resources effectively. However, according to the return on equity formula, the ROE is still higher (0.40 * 0.30 * 5.00 = 0.60) because of the other two components.

The profit margin for Firm B is substantially lower, at just 20%. Its financial leverage is also relatively low at 0.60. However, the overall asset turnover is 5. As a result, Firm B has performed well in terms of Return on Equity (0.20 * 5.00 * 0.60 = 0.60) due to its higher asset turnover.

Imagine what would happen if investors examined the ROE of these two companies. They would only discover that the ROE is quite favourable for both companies. But only after analyzing the fundamentals of both companies would the investors learn the truth.

Conclusion

Investors who use ROE can make wise financial judgments. You can develop a wise investing strategy by calculating ROE and using it when comparing businesses. Before choosing where to put your money, be aware of how businesses strive to reach their favourable ROE. So, try to compare businesses within the same industry and sector. 

FAQ

Q. Why Is ROE vital?

Return on Equity (ROE) examines the company's bottom line to determine its overall profitability for owners and investors. Considering that shareholders are at the bottom of a company's capital structure, the income paid to them is a helpful indicator of the excess profits after paying necessary commitments and reinvesting in the company.

Q. What are the ROE's limitations?

ROE requires a lot of input. Therefore, the entire process is flawed if there is even one mathematical error. Additionally, the source of information must be trustworthy. A flawed computation results in a flawed interpretation.