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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.
- 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%
- 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.
- 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.
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.
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).