ROE Calculator

Understanding Return on Equity

ROE is one of the most commonly used indicators of a company's profitability, and it's expressed as a relation of a company's net profit to shareholders' equity. Simply put, Return on Equity measures a company's efficiency in generating profits. 

When to use the ROE calculator:

• To calculate the profitability of a company
• To forecast future profitability
• To compare companies

When not to use ROE

Although the ROE ratio is a very popular metric, there are cases when other metrics should be applied instead. The most important constraint of this indicator is not considering time frame and debt. If your company uses debt as leverage, you should use a ROCE calculator instead.

Characteristics

• It is a simple method of analyzing a company's profitability.
• It is a universal metric that can be applied to any asset company.
• It's expressed as a percentage value.
• Can take positive or negative ROE values

How to calculate ROE?

Return of Equity is a net income ratio to shareholders' equity, usually expressed as a percentage value.

Return of Equity formula

ROE = (net_income / equity) * 100%

Where:

• Net income - The company's net profit before the dividends were paid.
• Equity - Does not include any debt. 

Each value for calculating this metric can be found in the company's balance sheet or income statement.  

Key takeaways

• Since the company may generate profit or loss. Return of Equity may take positive or negative values.
• For a company with negative equity and generating a loss, ROE may take high values, which may be misleading. So in such cases, ROE should not be calculated.
• Time is not a part of the equation. So when comparing companies, you should calculate ROE for periods of the same length.

What is a good Return on Equity?

There is no simple answer to that question. Of course, the higher, the better, but an ROE of above 10% is considered a good return on equity. 

To be even more precise, you should consider it good practice to compare ROE to the average ROE for the particular industry.

There are industries where ROE above 20% is ubiquitous, while 5% can be a challenge for the others. 

Pros and cons of ROE indicator

The advantages of ROE

Easy to use

For sure, simplicity is the most significant advantage of this indicator. The concept is easy to understand, but each underlying variable (net profit and equity) is precisely defined. 

A quick comparison of companies

A single percentage value given by the ROE formula allows us to compare the performance of many different companies within a few moments.

The disadvantages of ROE

Although ROE is a handy and popular indicator for good reasons, certain risks need to be considered to use this gauge properly and draw the correct conclusions.

Debt is not considered.

It is not always the drawback since ROE is for analyzing the company's performance in generating profits from its equity. Still, you should be aware that companies that use debt extensively can have high ROE at the expense of future earnings since all debt needs to be sooner or later paid off. 

Does not take time into consideration

The ROE equation has no time variable, so time frames are not considered when calculating this metric. But for obvious reasons, ROE calculated for one quarter is not relevant to ROE for the whole year.

May be misleading

ROE is a straightforward concept, but this simplicity comes with a cost. Not all the factors are considered while calculating this indicator. So in some cases, other metrics are better for specific comparisons. To name just a few, we can enumerate Return on Capital Employed, Return on Sales, and Return on Invested Capital.

Risk is not considered.

A single numeric value is not a good approximation of a company's attractiveness. Since in one year it may generate very high profits and there might be a loss next year. ROE does not consider such volatility, but it's a crucial metric for every investor.

Understanding ROE in Investments with Debt Leverage:

Return on Equity isn't just a metric for businesses; it's also applicable to individual investments, like purchasing a rental property with a mortgage. Here's how debt plays a role in such scenarios:

When you invest in something like a property to rent out, you're essentially using your own capital (equity) and potentially some debt (like a mortgage). ROE helps you understand how effectively you're using your own money to generate returns, irrespective of the borrowed funds.

Excluding Debt from the Equation

In the ROE calculation, the focus is on your equity – the down payment you made, not the total purchase price including the mortgage. This focus helps isolate the profitability of your direct investment.

While debt isn't directly factored into the ROE calculation, it affects the total equity you have in the investment. For instance, a smaller down payment (higher debt) results in less equity, which can inflate the ROE, giving the impression of higher profitability.

A high ROE in a leveraged situation might look attractive, but remember it might also indicate higher risk. If your investment faces challenges, like unexpected maintenance costs or vacancies, your actual return on equity can be significantly impacted.

It's important to not rely solely on ROE, especially in leveraged investments. Consider other factors such as cash flow, the cost of the loan, and the potential for property value appreciation or depreciation.

Conclusion

Whether it's a company or an individual investing in property, ROE helps in understanding the efficiency of using equity to generate returns, separate from any debt involved. For leveraged investments, ROE can be a valuable tool to assess the performance of the invested capital, but it should be interpreted with an understanding of the associated risks and in conjunction with a broader financial analysis. This approach ensures a balanced view of the investment's profitability and sustainability.

The Relationship Between Leverage Ratios and ROE:

Leverage ratios and Return on Equity are interconnected in a way that is crucial for investors to understand. Here's how they relate:

What is a Leverage Ratio?

A leverage ratio measures the degree to which a company is financing its operations through debt. Common leverage ratios include the debt-to-equity ratio, the debt-to-asset ratio, and others. They give an idea of how much a company relies on borrowed funds versus its own capital.

Impact on ROE:

When a company uses high levels of debt (high leverage), this can lead to an inflated ROE. Here’s why: ROE is calculated by dividing a company's net income by its shareholder equity. If a company has taken on a lot of debt, its equity is lower (because equity = assets - debt). So even if the net income remains the same, a lower equity denominator in the ROE formula results in a higher ROE.

This inflated ROE can give a misleading impression of a company's operational efficiency. A high ROE might seem to indicate that a company is doing a great job of generating profits from its equity, but in reality, those profits could be more a result of high financial leverage rather than operational excellence.

Higher leverage means higher risk. If a company is heavily reliant on debt, it may face greater financial stress, especially if interest rates rise or if there are downturns in revenue. This risk isn't directly apparent in the ROE figure.

Therefore, when evaluating a company's financial health and performance, it's important to look at ROE in conjunction with leverage ratios. This gives a more complete picture. While a high ROE could be a sign of efficiency, it’s crucial to check whether it's driven by high leverage. If that's the case, investors should tread cautiously.

While a high ROE can be a good sign, it's important to understand how much of that is fueled by debt. By looking at leverage ratios alongside ROE, investors can better assess whether a high ROE is due to effective management and business operations, or simply a result of high financial leverage. This understanding is key to making informed investment decisions.

Example ROE calculation

In order to better illustrate ROE applications, let's analyze the performance of the imaginary company ACNE Corp. 

The company generated over one fiscal year net profit of $230,000 from $750,000 shareholders' equity. So, in this case:

ROE = ($230,000 / $750,000) *100% = 30,6%

The effective ROE of 30.6% is an excellent result. 

FAQ

What's the difference between Return on Assets (ROA) and ROE?

Both indicators can be used for measuring a company's profitability. The critical difference between those two metrics is how they treat debt. 

ROA takes into account the company's liabilities, and ROE doesn't. So companies with debt will have higher Return on Equity and lower Return on Assets (since debt increases the denominator in the equation).

Authors

Created by Lucas Krysiak on 2022-03-12 14:32:36 | Last review by Mike Kozminsky on 2022-09-15 13:47:50