﻿ Return on Equity (ROE) - What is it, formula, Limitations

# Return on Equity (ROE)

## What Is Return on Equity (ROE)?

Return on Equity is measured by dividing a company’s net income by its shareholder equity. The return on equity (ROE) is a measure of a company’s profitability and indicates how effectively the company is making profit.

## Formula and Calculation of ROE

ROE is expressed in percentage terms and can be calculated for any company provided that the net income and equity are not negative. This formula is used to calculate ROE;

ROE = Net IncomeAverage / Average Shareholder′s Equity

## Interpreting the ROE Metric

ROE tells us about a company’s profitability and how effectively it makes money. A good ROE indicates effective production. However, an extremely high ROE can be an indicator of problems like excessive debt and inconsistent profit. A low ROE metric ratio indicates the bad shape of the company.

## Variations on the ROE Calculation

The ROE calculation can be affected by various factors, of which the most important is leverage. A debt-financed company is more likely to have a lower after-tax profit than an equity-financed corporation due to loan interest payments. Calculations of ROE can be affected by this as excessive debts and inconsistent profits lead to an extremely high ROE.

## ROE Formula Drivers

Operating efficiency, asset use efficiency, and financial leverage drive the ROE formula. Operating efficiency means the net income divided by the total revenue. Asset use efficiency measures how effectively assets are used by a company to generate profits. Financial leverage is an analysis that is used to assess a company’s use of debts to finance its assets.

## The DuPont formula

The DuPont analysis is a methodology for analysing fundamental performance and is used to compare the operational efficiency of two companies that are identical. The DuPont analysis is a strategy that breaks down ROE into three parts to understand the changes that take place over time.

ROE = Net Income /Sales × Sales/Total Assets × Total Assets/Average Shareholder′s Equity

## Impact of Leverage on ROE

As equity equals assets minus total debt, a company’s equity as a percentage of assets can be reduced by raising debt. This can be understood from the following example:

Annual Profits = \$3,00,000

Shareholder’s Equity =  \$5,00,000

ROE = 3,00,0005,00,0003,00,0005,00,000

= 0.6%

Loan = \$2,50,000

New Shareholder’s Equity = \$2,50,000 (assets – liabilities)

ROE =

3,00,0002,50,0003,00,0002,50,000

= 1.2%

## Return on Equity and Stock Performance

ROE can be used to estimate long-term growth rates and dividend growth rates, provided the ratio is close to or slightly above the peer group average. ROE is a good place to start if one wants to estimate a stock’s future and dividend growth rate. These two calculations are functions of one another, and they can be used to compare similar businesses.

## ROE vs ROA

There are significant differences between ROE and ROA even if both of them are used to measure profits. Return on Assets (ROA) takes leverage or debt into account but ROE does not. ROE uses net income and divides it by shareholder equity. There are differences between their formulas as well;

ROA = Net Income/Total Assets × 100

ROE = Net Income/Shareholder Equity × 100

## ROE and Capital Raising

A rising return on investment (ROI) indicates that a corporation is generating more profits with less capital. It also shows how successfully a company’s management manages shareholder money. A higher ROI is normally preferable, however, a declining ROE may suggest inefficient use of equity capital.

## Using Return on Equity to Identify Problems

Problems like excessive debt and inconsistent profits can easily be identified using ROE. This is because excessive debt and inconsistent profits yield a very high ROE, which in itself is an indicator of problems. It can also be used to identify problems or factors that can pose a risk to a company’s profitability.

## Limitations of ROE

An important limitation of ROE is ROE being calculated as too high. This indicates various problems like excessive debt or inconsistent profits. This is a limitation as it then cannot be used to assess a company’s profitability. It can also be misleading when new companies are in question as there is a high requirement of capital which results in low ROE. It can also be easily manipulated by decreasing or increasing rates accordingly.

If ROE is too high, it indicates risk which can cause many problems. This can lead to inconsistent profits due to an extremely low denominator, which gives you a misleading ROE. Excess debt can also result in ROE, which means that there is low equity. It can also show a negative net income.

ROE tells us about a company’s profitability and how effectively it makes money. A good ROE indicates effective production and the company is considered to be in good shape if ROE is above 15%. A high ROE, however, is not a good indicator. A good ROE lies between 15% and 20%.

A company can have a low ROA even if it has a high ROE. This indicates that while the company is successful in managing its equity, it is not as successful in managing its assets. This could be because ROA considers debt. Therefore, it is better to keep the two separate and use ROA when debts are to be considered and use ROE when there is a question of equity management.

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