Return on Equity – or ROE to use the abbreviation – is an important financial metric used to measure the profitability of a business in relation to stockholder’s assets.
But what exactly does this mean? How is ROE calculated? And does it really matter that much?
Continue reading as we answer these questions and more.
What is Return on Equity (ROE)? How is ROE calculated?
Return on equity is a measure of financial performance within a business. It is calculated by dividing net income by shareholders equity. Shareholders equity is the equivalent of a company’s assets minus its debt, therefore ROE is deemed to be the return on net assets. ROE is measured as the profitability of an organisation related to the equity of the stockholders.
When calculating return on equity, it is equal to a fiscal year net income divided by total equity (excluding preferred shares) expressed as a percentage. When using the fiscal year net income in your calculation, bear in mind that this is after preferred stock dividends but before common stock dividends.
Looking for more financial calculations? Check out our infographic on understanding gross profit.
What is ROE used for?
ROE is used when comparing the financial performance of companies within the same industry. It is a measure of the ability of management to generate income from the equity available to it. A return of between 15-20% is considered good. ROE is also used when evaluating stocks, as well as other financial ratios. However, it is important to note that there are many different factors to consider when evaluating stock than return on equity alone.
Advantages of ROE
- It outlines the percentage return earned by equity shareholders
- It clearly shows how good a company is at generating benefits for its shareholders beyond earnings
- It helps investors to compare the performance of different equity investments and influence their future investment strategy.
Limitations of ROE
- In the first days of a new company, capital requirements are high to get the business going, therefore, ROE can misleadingly appear lower.
- ROE can be easily manipulated by accounting trickery.
Using Return on Equity formula To Estimate Growth Rates
Return on equity formulas can be used to estimate sustainable growth rates and dividend growth rates, as long as the ratio is approximately in line with or just above its peer group average. Calculating ROE can be a good starting point for developing future estimates of the growth rate of a stock and its dividends.
How ROE is used to identify problems
One would think that stocks with a higher ROE are better value, but this is not always the case.
A very high ROE is a good thing if net income is extremely large compared to equity of a company’s strong performance. However, an extremely high ROE is often because of a small equity account compared to net income, which shows risk.
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