Return on Equity

Understanding return on equity

Return on equity can be very informative for potential investors, but it relies on knowing other factors such as industry averages. Knowing if an ROE is good or not relies on this context, so a healthy ROE can be identified by comparing a business with the average for its peers.

In general, the higher the number for ROE the better, and a low or negative ROE can indicate problems. It’s also worth remembering that an unusually high ROE can also indicate issues such as a sudden windfall after consistently low profits, or an excess of debt.

How to calculate return on equity

The formula for return on equity is net income divided by shareholder equity. Net income represents a company’s bottom line profits reported on the income statement, before stock dividends are paid out. You could also use free cash flow (FCF) instead of net income to assess profitability.

To work out shareholder equity, a company’s liabilities must be subtracted from its assets, showing what is left over for dividends should a company settle all its liabilities.

Using ROE

Return on equity can be used to estimate a company’s growth rates, and predicting how stock will grow and produce potential dividends. To get a clear picture of your company’s potential for growth, you’ll need to multiply the established ROE with your retention ratio – another metric which measures how much of your business’ revenue can be set aside for growth.

ROE can be an industry-specific metric to measure, meaning that the nature of its value will depend on competing stocks within the industry. To clarify – different industries have different expectations of their ROE, so this must be taken into account when using ROE as a metric for performance and growth potential.

You’ll want to aim for your ROE to hit just above the average for the rest of your industry, this gives a manageable target that can be built on as your investments grow. If you’re getting a high ROE, this can indicate to both you and your peers that your equity account is small against your net income – which can be a sign of an unstable and risk-leaden financial situation.

What is the difference between ROI and ROE?

Both ROI – return on investment – and ROE – return on equity – can be invaluable tools for seeing how well a business is performing financially. Businesses use these metrics to forecast and plan for growth.

There are significant differences however. ROI indicates the profitability of an investment, showing the potential returns an investor can get from their investment against the investment’s cost. To establish ROI, you need to divide the investment’s profit by the amount of the cost.

ROE in contrast, is a metric that shows the how profitable a business is because of its equity. It demonstrates the return on assets owned by the business minus any debts or liabilities that the business has. It is industry specific and shows how good the business is at turning its equity into profits.