What is ROE? The ROE index is one of the metrics used by analysts and shareholders to assess a company’s profitability and its future growth potential. However, to understand the true significance of the ROE index, let’s delve into all the information about ROE in the content of this article.
Contents
What is ROE (Return On Equity)?
ROE stands for Return On Equity, which means the rate of Net Income on the Shareholder’s Equity. Simply put, it’s a metric that measures the profitability of an investment for every dollar of equity invested and also measures a company’s efficiency in using its capital.
Example: You start a coffee shop business using your own pocket money (without borrowing from other sources). After operating for 12 months, you begin to make a profit. ROE is the ratio of profit to the capital you invested.
ROE is an important metric for potential investors to gauge how a company will use their money to generate profits.
ROE Calculation Formula
ROE, represented as a percentage, can be computed for any corporation where both net income and equity are positive. Net income is determined after accommodating for dividends to preferred shareholders and interest to lenders, and before distributing dividends to common stockholders.
ROE = Net Income/ Shareholder’s Equity* 100%
Net income signifies the total earnings of a company after deducting expenses and taxes for a specified period. To calculate average shareholders’ equity, one must add the equity value at the start of the period. This period should align with the time frame in which the net income was generated.
The net income for the most recent complete fiscal year, or the past 12 months, can be located on the income statement, which records the financial activities over that duration. Shareholders’ equity is derived from the balance sheet, which continuously tracks the evolution of a company’s assets and liabilities.
Example:
- Net Income: 10,000 USD
- Shareholder’s Equity: 100,000 USD
=> ROE = 10.000/100.000 = 0,1 hay 10%
This means that for every 1 USD of business capital invested, the company earns back 0.1 USD of net profit.
How is ROE Different from ROA?
Many people often confuse ROA with ROE, as their calculation formulas and meanings are similar.
To simplify, understand:
Total assets = Owner’s equity + Liabilities
In the formula, ROA is the rate of net profit to total assets. Whereas, ROE is the rate of net profit to owner’s equity.
*** Liabilities: These are borrowings from outside to invest in production and business. If a company does not have external debts, then ROA = ROE.
Significance of the ROE Index
The ROE index is an accurate measure to evaluate how much profit a single dollar of investment generates. Businesses often use this index to compare profitability across quarters within a company or between different companies, thereby deciding which company’s shares to buy.
ROE can be calculated for any company if both net income and owner’s equity are positive. If a company has a negative profit (loss), ROE is usually not calculated.
After knowing the ROE index, investors can evaluate from specific perspectives:
- If ROE is less than or equal to the bank interest rate, and the company has lower shareholder capital than bank loans, then the profits generated are only enough to pay bank interest.
- If ROE is higher than the bank interest rate, it’s necessary to see whether the company has maximized its competitive advantage on the market, thereby evaluating if the company can increase its ROE ratio in the future.
What is a Good ROE?
In theory, a high Return on Equity (ROE) is a positive indicator, signifying efficient use of shareholder capital by a company. Consequently, stocks boasting high ROE ratios often appeal more to investors.
Yet, for a precise evaluation of what constitutes a good ROE, it’s essential to benchmark a company’s ROE against the industry average. Different industries characteristically exhibit varying ROE levels, making it meaningful to compare ROEs only among companies in the same sector.
For example, in the consumer goods industry, which requires high capital investment, an ROE of at least 16% is considered decent. But for the technology industry, an ROE of 22% is required to be considered effective.
And when evaluating a company’s ROE index, analysts usually don’t assess based on a single year but over a period of at least 3 years. A company with an ROE of over 20% for three consecutive years can be seen as having good competitive strength.
What About Excessively High ROE?
While a high ROE is very good, indicating large net income and strong company performance, in some cases, an extremely high ROE can hide many company issues, including:
- Excessive Debt
The first potential issue with high ROE is that the company might have too much debt (borrowed heavily from outside, with little owner’s equity). Since ROE is calculated as profit/owner’s equity, the more the company borrows, the less the owner’s equity, meaning the company could face increased risks.
- Inconsistent Profits
The next potential issue with high ROE is inconsistent net profits. For example, company A operates without profit for several years, with losses recorded on the balance sheet as “retained losses.” This loss is a negative value and reduces shareholder equity. Then, if company A becomes profitable in a year, it leads to an abnormally high ROE.
- Negative Net Income
Finally, in cases where net income is negative, and owner’s equity is negative, it can produce a falsely high ROE. Therefore, if a company has net losses or negative owner’s equity, ROE should not be calculated.
=> In summary, in any case, an extremely high ROE is a warning sign that requires investigation.
Limitations When Calculating ROE
Although the ROE index can help investors compare the performance of different stock investments, it also has several limitations, such as:
- Misleading for new companies, as they usually require high capital in the beginning, leading to low ROE.
- ROE can be easily adjusted using accounting operations like increasing project lifespan, reducing depreciation rates, etc.
- The ROE index can be distorted when a company reduces owner’s equity by buying back treasury stocks. Here, the profit remains unchanged, and owner’s equity decreases, leading to an increase in the ROE ratio.
Therefore, we should not rely solely on the ROE index but need analysis, comparison, and evaluation, along with other financial metrics and assessments of the companies themselves within the same industry to make informed investment decisions. Wishing you wisdom and a smart investment strategy for the future.
