In the previous blogs, we understood the meaning and application of the accounting ratios of Return on Investments (ROI) and Return on Assets (RoA). While ROI gives an insight into overall profitability, ROA focuses on the returns generated through the efficient use of the assets a company possesses.
In this blog, we will take a look at the one of most crucial aspects of returns that directly impacts the shareholders.
Equity signifies the amount of ownership an investor has in a company. It is the share of the money that an investor has invested in a company. Hence, the ratio of return on Equity suggests a company's ability to return profits to its shareholders. It is a ratio that holds the highest importance for any shareholder. RoE is an indication of how well a company uses its shareholder's funds.
Any potential investor or an existing one would want to know the company's current or previous RoE to understand the company's capability of returning the shareholder's worth of invested money and to give them profits as well. The higher the RoE, the better are the odds in favor of an investor to that company, in terms of returns.
Return on Equity Meaning
The return on equity ratio of a company measures the rate of return which the owners of the common stock of the company get in return for their shareholding. Return on Equity informs how efficient a company is in providing returns to the investments which it has received from its shareholders.
Return on Equity (ROE) measures a company's annual return or net income divided by the value of its shareholders' total Equity.
ROE is also considered as a measure to understand how efficiently a company is using its assets to generate profits. ROE represents the total returns on its equity capital and shows the company's ability to turn its equity investments into profits. In simpler words, it measures the profit made on every 1 rupee of shareholders' Equity.
Calculating Return on Equity
ROE is the ratio of a company's net income and shareholders' Equity. It is expressed as a percentage value and can be calculated if both income and Equity are positive values.
Return on Equity = Net Income / Shareholders’ Equity
Net income is the amount of profits left after deducting the net value of expenses and taxes for a given period. Net income of the required financial year can be found from the company's income or profit/loss statement of that year.
Net income directly impacts the rise and fall of the ROE ratio. Higher revenue and lower costs would result in higher net income or if the revenue is increasing and the costs are consistent. Higher net income would result in a positive and high ROE ratio. At the same time, falling revenues and rising costs could mean lower net income or even losses. The ROE will be very low if the net income is lower than the shareholders' Equity.
Shareholders' Equity can be calculated by subtracting the total value of liabilities of a company from its total value of assets. Total Assets, total liabilities for a period, can be found in the company's balance sheet. It is the difference between total assets and total liabilities of a company. It is remaining the amount if a company decides to settle its liabilities at a given time.
Shareholders Equity = Total Assets – Total Liabilities
The above formula is valid if there is no preferred stock in the company. If preferred stock exists, the preferred stockholders' Equity is deducted from total shareholders' Equity to determine the total common shareholders' Equity.
A fall in the average shareholders' Equity would lead to a rise in ROE, and a rise in Equity will result in the fall of ROE.
For a more detailed evaluation regarding these components of Return on Equity, and how each of them affects the ROE ratio, a DuPont analysis. DuPont analysis will give a thorough insight into how each of these figures affects the ROE ratio. This will be discussed in the next blog of the series.
Example of calculating ROE
As per the last blog, it was evaluated that the net income of ABC Ltd is Rs 74.
Net income = Operating profit – Taxes
= 86 – (200*6%)
= 86-12 = 74
Also, ABC Ltd owns Rs as 200 Debt and Rs 300 Equity
ROE of ABC Ltd = Net Income / Shareholders’ Equity
= 0.246 or 25% (approx.)
ABC Ltd.'s Return on Equity is at 25%. This means that for every rupee invested in ABC Ltd, its investors would earn 0.25 rupees.
ROE provides a simple measure to understand the investment returns of a company. A company's competitive edge over its competitors can be analyzed after comparing its ROE with the industry average. ROE provides insight into how a company is using its shareholder's Equity to grow its business.
An increasing or consistent ROE can indicate that a company is good at generating value for its shareholders because it is reinvesting its earnings wisely. On the other hand, a company's declining ROE over a period of time will indicate that the company is not using its equity capital efficiently and is making poor investment decisions by investing in unproductive assets.
Importance of ROE
Return on Equity looks at the firm's overall ability to generate profitability for its shareholders, investors, and owners. Income returned to the stockholders determines excess income that remains after paying off necessary obligations and reinvesting it into the business.
In simpler words, ROE can help investors figure out if they will be getting a good return for their money invested into the company; and for a company, ROE can help understand how efficiently it is using its Equity.
For ROE to make sense and add meaning, it must be compared to the company's previous ROEs or the industry average to make a decision. The decision can be more informed if, with ROE, other accounting ratios of the company are considered as well.
ROE, if extremely high or negative, can be used to identify problems such as inconsistent profits, excess debts, and negative income.
Limitations of ROE
The return on equity ratio is not always considered as the perfect measure for evaluating a company's success or failures because of its following limitations:
A higher ROE is not always a positive indicator of a company's return of value to its shareholders. It can be indicative of various issues, such as negative income or inconsistent profits.
A negative ROE that arises from a company's net loss or negative shareholders' equity cannot be used to compare its performance with its previous years, nor can it be used to compare it with the industry or competitors with positive ROEs.
ROE can be heavily affected if a company's management decides to buy back its stocks from its investors. This results in a reduction in the number of outstanding shares. In such a case, the denominator of the ROE ratio (Shareholders' Equity = TA-TL), reduces, thus making the ROE inconsistently higher.
Some ROE calculations exclude intangible assets such as goodwill, trademarks, patents, copyrights, etc. This can make the ratio misleading and difficult to compare with other companies, which may include intangible assets.
Difference between Rate of Return and Return on Equity
Investors often face confusion when they come across these two terms, and some even consider them to have the same purpose. However, they carry significant differences:
In conclusion, Return on Equity is a measure to determine a company's ability to generate profitable returns for its shareholders for a given time period. However, considering its limitations, ROE should not be the only determinant while making investment decisions. ROE holds value only when it is compared with the ROE of the previous periods of the same company or with the market, which can often be misleading because of the differences in accounting practices and calculations. Apart from calculating ROE, investors can also figure out the return efficiency of a company by calculating its return on capital employed or ROCE and return on operating capital or ROOC, which can often be more useful and trustworthy. To understand the more detailed aspects of ROE and ROA ratios, one must perform the DuPont Analysis to get a more thorough insight and make a more informed decision.