How To Calculate Return On Equity - The Full Guide

By Samantha Clark

Dec. 13, 2022

181

Return on equity is classified as a ratio that enables investors to calculate how proactively their company is using shareholder’s money. In essence, a return on equity will measure the profits of a company in direct relation to the equity of stockholders.

The higher your return on equity, the more efficiently your company’s managers are at generating profits and growth from equity financing. ROE is also used to compare companies to their competitors within the relevant market.

This formula is highly useful when comparing firms within a specified industry as it provides indications of the companies that are generating greater efficiency financially. This is also beneficial when evaluating companies that have tangible as opposed to intangible assets.

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Table Of Contents

Formula And Calculation Of ROE
ROE Of The Stock Market
What To Do When A Shareholder’s Equity Is Negative
What Does ROE Tell You?
Conclusion

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Formula And Calculation Of ROE

The typical formula for calculating a return on equity is the following:

The net income is otherwise known as the bottom-line profit prior to the payment of common-stock dividends that are reported on the company’s income statement. An alternative form of profitability is Free Cash Flow or FCF that can be used in place of net income.

Shareholder equity is calculated by taking away liability from overall assets on the company’s balance sheet. This culminates in the accounting value that is leftover or shareholders once a company has settled liability within any reported assets.

It is important to note that a return on equity shouldn’t be confused with the overall return on assets or ROTA. Whilst ROTA is similar in the sense that it is a measurement of profitability, it is calculated differently by taking the company’s overall earnings prior to additional interest and/or taxes and dividing it by the overall assets.

ROE is also calculated at various times in order to compare its growth over a certain period of time. This is useful for investors as they can track the company’s growth from quarter to quarter as well as year to year to assess managerial performance.

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ROE Of The Stock Market

A key feature in knowing how and when to invest is to assess the overall stock market. For instance, when looking at ROE figures in a specific industry, you may note that this market is performing well. However, other sectors may be performing poorly. Thus, when deciding what to invest in, you should assess the overall market prior to making your decisions.

You should try to invest in a sector of the market where companies are showing steady growth as this will provide you with profitable returns. Once you have compared individual companies' ROE with the overall market, you can make an informed decision that will ensure that you are reaping the returns that you desire.

It is also worth noting that not all ROEs are the same and measuring a firm’s ROE performance against its specific sector is just one piece of analysis that you should be undertaking. For instance, in the latter quarter of 2020, the Bank of America had a 8.4% ROE whilst the average ROE for this specific industry at this time was 6.88%. Thus, the Bank of America massively outperformed within the financial sector.

Additionally, the ROE for commercial banks during the same period was 6.38% and as the Bank of America is also considered a commercial lender, it also over-performed in the commercial bank sector. Thus, it is important to compare a company’s ROE with other companies within the same industries.

When evaluating companies, many investors will also calculate the ROCE or return on capital employed. This is useful to ascertain a company’s longevity. Typically, both metrics are useful to indicate the overall capital of a business including manufacturing costs and utilities expenditure.

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What To Do When A Shareholder’s Equity Is Negative

Negative equity will normally occur whenever a company has incurred losses for a specific period of time and has borrowed money in order to continue operating. In this instance, the company’s liabilities will be far greater than its assets.

In order to calculate the ROE in this instance, it may not paint the entire picture. This is because it would indicate that the company isn’t making profit. Despite the fact that it may have positive shareholder equity.

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What Does ROE Tell You?

Return on equity will indicate how proactively a company is able to generate its profits. Typically, the higher a company’s ROE is, the better they are operating. However, it is also useful to assess companies within the same sector in order to make appropriate choices.

The average ROE for U.S. stocks in 2021 was 21.88%. However, it is important to note that various industry sectors will have ROEs that are grossly higher or lower than this specified average. Thus, you should always engage in thorough research when making calculated investments.

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Conclusion

To conclude, a return on equity indicates how efficiently a company is working. It is used by investors to calculate which companies are functioning with high profits. This calculation can depend on external factors like the overall market, however, some companies may outperform the overall market and thus, it is important to make comparisons within the specified sector when investing.

Calculating a company’s ROE can be done throughout the year, from quarter to quarter, which is useful for CEOs to calculate managerial progress and ascertain whether the company is making relative profits for shareholders.

In some instances, companies may generate negative equity. This usually occurs when a company has incurred substantial losses over a specific period of time due to outbound payments like liabilities and utility costs. You should assess these companies by comparing them to companies within the same sector. It may be that the market for this specific sector is suffering losses overall and thus, investing in a company that has the least losses may be profitable for you in the long term.

As always, when making calculated investments, you should engage in research. Calculating a company’s quarterly ROE is undoubtedly the best way to do so.

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Frequently Asked Questions

While ROE is a useful metric for evaluating a company's profitability and efficiency, it has limitations. For example, it can be skewed by high debt levels or fluctuations in a company's net income. Additionally, ROE may not be the best indicator of a company's performance across different industries or business models. It is essential to use ROE in conjunction with other financial metrics for a more comprehensive analysis.

Yes, ROE can be negative if a company's net income is negative, which means the company is losing money. A negative ROE indicates that the company is not generating profits from its shareholders' equity.

Companies can improve their ROE by increasing net income, reducing debt, or repurchasing shares to decrease shareholders' equity. However, it is essential to consider the potential risks and benefits of these actions on the company's overall financial health.

To compare companies using ROE, you can look at their ROE ratios to evaluate their profitability relative to the equity invested by their shareholders. A higher ROE generally indicates better financial performance and more efficient use of shareholders' investments.

ROE is calculated using the formula: ROE = Net Income / Shareholders' Equity.

Debt can affect ROE because a company's shareholders' equity is calculated by subtracting total liabilities (including debt) from total assets. If a company has a high level of debt, its shareholders' equity may be lower, leading to a higher ROE. However, this may not always indicate better financial performance, as a higher debt level can also increase a company's financial risk.

ROE measures a company's profitability relative to the equity invested by its shareholders, while ROA measures a company's profitability relative to its total assets. Both ratios help investors gauge a company's financial performance, but they focus on different aspects of that performance.

A good ROE varies by industry, but a general rule of thumb is that an ROE above 15% is considered good, indicating the efficient use of shareholders' equity to generate profits.

Return on Equity (ROE) is a financial ratio that measures a company's profitability relative to the equity invested by its shareholders. It is calculated by dividing a company's net income by its shareholders' equity.

ROE is important because it helps investors evaluate a company's ability to generate profits from its equity. A higher ROE indicates that a company is using its shareholders' investments more efficiently to generate profits.

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