Return On Equity (ROE)

Return On Equity (ROE)

Return On Equity (ROE) is an accounting method similar to Return on Investment (ROI) that is used as a measure of a corporation's profitability that reveals how much profit a company generates with the money raised from shareholders.

It is also a measure of how well a company used reinvested earnings to generate additional earnings, equal to a fiscal year's after-tax income (after preferred stock dividends but before common stock dividends).

How is the Return On Equity (ROE) ratio used?

It is used as a general indication of the company's efficiency; in other words, how much profit the company is able to generate given the resources provided by its stockholders.

Investors usually look for companies with returns on equity that are high and growing.

What is the formula for calculating the Return On Equity (ROE) ratio?

                               Net Income
Return on Equity = -------------------------------------
                     Book Value of Shareholders' Equity

Return On Equity (ROE) ratio values

ROE is expressed as a percentage. The higher the ratio, the more efficient the company was in utilizing invested capital.

For most of the twentieth century, the ROE of S&P 500 companies average between 10 to 15%. In the 1990’s, the average return on equity was in excess of 20%.

Disadvantages of using the Return On Equity (ROE) ratio

ROE is sensitive to leverage.  Assuming that proceeds from debt financing can be invested at a return greater than the borrowing rate, ROE will increase with greater amounts of leverage.

Because the numerator (Net Income) is not always reliable, it can be inflated by accounting practices, the value of ROE alone is also not completely reliable. ROE alone cannot be used to judge a company, but it can be used in conjunction with other measures.

The degree to which Return On Equity (ROE) overstates the underlying economic value depends on several factors:

  1. Depreciation: Depreciation rates faster than straight-line basis will result in a lower net income and therefore also in a lower ROE.
  2. Growth rate of new investment: Faster growing companies will have lower Return On Equity because they need more equity.
  3. Length of project life: The longer lifespan a project has, the more likely the ROE is going to be overstated.
  4. Capitalization policy: The smaller the fraction of total investment is capitalized in the books, the greater will be the overstatement of ROE.
  5. Lag between investment outlays and their recoupment: The longer it takes to recoup profits, the greater the degree of overstatement.

The ROE ratio has other names too.

Other names for the Return On Equity (ROE) ratio

Return On Equity (ROE) is known also as Return on Net Worth (RONW).

Alternative calculation

In some cases the Return on Equity may be modified using the following formula:

                      Net Income - Preferred Dividends
Return on Equity = -------------------------------------
                              Common Equity

Preferred dividends are subtracted from net income.

Preferred equity is subtracted from shareholders' equity.

Is there any other ratio related to this?

Yes, finance practicioners use many other ratios when they analyze finance. For example the following:

Acid Test Ratio,

Capital Adequacy Ratio (CAR),

Return On Assets (ROA),

Return on Investment (ROI),

or the Cash Asset Ratio (CAR).


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