What Is Return On Equity?
The return on equity (ROE) is a measure of corporate profitability. It measures how much profit a company generates from shareholders equity, which is the company's total assets minus its total liabilities.
ROE is expressed as a percentage, and it can be measured by a fairly simple equation: ROE = net income divided by shareholders equity. For example, if a company had US$1 million of net income and its shareholders equity was US$5 million, its ROE would be 20%.
ROE measures how efficiently a company uses its equity, namely its ability to generate profits without needing as much capital. The higher the ROE, therefore, the better. Basically, it shows how much profit a company can generate from each dollar invested in it. And in the above example, it's 20 cents, or 20%.
ROE Can Be Manipulated
Companies can artificially boost their ROE. Stock buybacks reduce the amount of available equity (i.e., the denominator in the equation), thus raising the ROE. Likewise, if a company is more dependent on debt and less on equity, that would also serve to reduce the denominator, thus raising ROE.
For example, if a company has total capital of US$10 million, but 50% of that is debt, its stockholders equity would only be US$5 million, thus raising its ROE. If the company had US$1 million of net income, its ROE under the all-equity scenario would be 10%, but 20% under the half debt-half equity structure. The company's cost to service that debt would also reduce profits.
As a result, investors also need to look at another ratio called return on assets, which includes debt financing. Both assets and equity are part of a company's balance sheet.
Companies can also choose to write down the value of certain assets, which would reduce their equity and therefore raise ROE. As a result, it's important for investors to track a company's ROE over time to see if there have been any significant changes recently that may have distorted the ROE.
ROE Varies By Industry
Returns on equity vary considerably from one industry to another. As a result, investors should compare the ROE of a given company against its industry peers to get a fair reading. Banks and utility companies, for example, generally have a lot of assets, whether financial or physical or both, and therefore tend to have relatively low ROEs.
- The average ROE for all U.S. banks in the second quarter of 2019 was about 12%. Bank ROE has been around 15% historically.
- Companies in the U.S. electric utility industry have an ROE of about 10%.
- By contrast, industries where companies don't typically have a lot of assets, such as retailers and technology companies, tend to have relatively high ROEs (over 20%).
How Investors Can Use ROE
ROE can often provide information about a company's future prospects, such as:
ROE can indicate how fast the company is likely to grow in the future. In the above example, the company had a 20% ROE, meaning it generated 20% on each invested dollar. If the ROE is higher, the company can be expected to grow at a stronger pace, other things being equal.
While a high ROE can't predict that a company will start paying a dividend or raise its current payout, it can show that the company can afford to do so. If it uses its capital more efficiently, it should be able to pay larger dividends.
The return on equity ratio measures how much profit a company generates from shareholders equity, which stems from the balance sheet. It involves dividing net income by equity, which is assets minus liabilities.
Generally speaking, the higher the ROE the better, but companies can reduce equity—and thus artificially raise their ROE ratio—by buying back stock, relying too much on debt financing, and writing down assets. Companies in the same industry usually have similar ROEs. Corporations with a lot of assets, such as banks and utilities, usually have low ROEs, while those with relatively few assets, like retailers, generally have higher ROEs.
Senior Market Specialist
Russell Shor (MSTA, CFTe, MFTA) is a Senior Market Specialist at FXCM. He joined the firm in October 2017 and has an Honours Degree in Economics from the University of South Africa and holds the coveted Certified Financial Technician and Master of Financial Technical Analysis qualifications from the International Federation…