Return on Equity (ROE) is a financial metric that measures the profitability of a company by evaluating how effectively it generates profits using shareholder investments. Therefore a high ROE is an indication of good investment and high profits.
But this is not always so. For instance, a company can record a significantly high ROE after years of losses and a sudden windfall. Therefore a good or bad ROE depends on the industry's average.
How to calculate Return on Equity (ROE)
There are different formulas for calculating ROE. However, the most common formula is ;
ROE = [Net Income]/[Shareholder's Equity]. Every other formula is a derivation of this one formula.
Net Income = total income, expenses and tax for a given period; Shareholder's equity = [total assets - total liabilities].
Another way of calculating ROE is as a function of ROA (Return on Asset). Where ROE = [Return on Asset] x [Leverage]
Importance and interpretation
Return on Equity is an important metric with which investors can determine if they are making any profits from their investment. The company can also use it to measure how good the firms equity is being used in generating profit for its investors.
ROE is not a standalone metric, that is to say it is not used in isolation. As seen from the formulas, ROE is interrelated with other key metrices such as the Return on Assets as well as leverages.
The Du Point Formula breaks down ROE into three key factors each of which directly impact a company's ROE. These factors are; the net profit margin, asset turnover and financial leverage. An increase in any or all of these factors will result in a higher Return on Equity.
But there is a caveat and that is leverage.
Limitations and considerations
Leverage is the use of debt to finance any revenue generating undertaking of a company such as procuring an asset. A high leverage can be deceptive. On one side, it boosts the company's ROE and on the other side it entails a high risk especially if the investment does not turn out as expected.
This is why a high ROE does not always mean that the company is profitable. Because it could also mean that the company is neck deep in debts. Other inconsistencies that can result in a high ROE are inconsistent profits and negative net income.
This is why the industry average is often used to gauge if a company's ROE is too high (which can be problematic) or well within the accepted range in the industry.