The return on equity (ROE) ratio shows how well a company uses the money its shareholders have invested. Thus, ROE quantifies a company's profitability regarding its stockholders' equity. The greater the ROE, the more effectively the company's management can turn its equity investment into profits and growth.
It tends to indicate accurately which companies are operating with greater financial efficiency. Like any other financial ratio, return on equity is most useful when comparing businesses operating in the same sector.
Simple Return on Equity Formula
Before dividends on common stock are distributed, a company reports its net income on its income statement. Net income isn't the only measure of success; free cash flow (FCF) can stand in its place. When a company's debts are paid off, and all of its assets are used to cover them, the remaining amount is the shareholder equity on the balance sheet.
Return on equity (ROE) should not be confused with return on total assets (ROTA) (ROTA). A profitability statistic, ROTA, is determined by dividing EBIT by total assets.
Return on equity (ROE) can be computed over time to examine its development. Investors can monitor management performance by comparing the growth rate of return on equity (ROE) from one period to the next, such as one year or quarter.
Return on Equity Measures Vary
One way to evaluate a firm's success is to compare its return on equity (ROE) to the average in its industry. For instance, Bank of America Corporation (BAC) had an ROE of 8.4% in the fourth quarter of 2020. In the same time frame, the average return on equity for banks was 6.88%, as the Federal Deposit Insurance Corporation (FDIC) reported.
Therefore, Bank of America's performance was better than average. Furthermore, the FDIC calculations include commercial and consumer banks and community banks. In the fourth quarter of 2020, commercial banks saw a return on equity of 6.38 percent.
Bank of America has a higher return on equity than most commercial banks, even though it is just a commercial lender to a limited extent. A company's return on investment (ROI) should be evaluated against the industry average and other companies in the same sector.
Return on capital employed (ROCE) and return on operating capital (ROC) are two additional metrics that are used by confident investors when assessing a firm's performance (ROOC). When evaluating a company's sustainability, investors typically look to ROCE rather than the more common ROE. Both are more actionable indicators for capital-intensive industries like utilities and manufacturing.
In the event of a negative shareholder equity
Sometimes a company's equity will be negative. This is the case when a company has been losing money for a while and has had to take out loans to keep operating. In this scenario, debts outweigh assets.
In this case, even if profits are positive, calculating return on equity would yield a negative result; nevertheless, this would be incomplete information. If a corporation operates at a loss but has positive shareholder equity, the return on equity will also be harmful.
If the return on equity (ROE) is negative due to falling shareholder equity, a more significant negative ROE is preferable. It would entail greater profits, suggesting the company had a chance of remaining financially stable in the long run.
The interpretation of ROE will alter depending on the underlying financials, such as when equity changes owing to share buybacks or when income is low or damaging due to a one-time write-off. You must comprehend the parts.
Average Return on Equity for U.S. Stocks
In 2021, the average return on equity for the stocks in the S&''P 500 was 21.88%. The average return on equity (ROE) in a particular industry will be higher or lower than the average for a different group of industries
In a DuPont Analysis, How Do You Determine Return On Investment? DuPont analysis is an additional method for determining ROE. Two such variants exist, one of which breaks down return on investment (ROI) in three stages and the other in five:
Concluding Remarks
To gauge the effectiveness with which management employs shareholders' equity financing, a critical financial statistic is a return on equity (ROE). Net income is weighed against stockholder equity.
Generally, a higher number is preferable, though comparisons should be made only between companies in the same industry. This is because the nature of each sector affects the profitability and resource allocation of its businesses in unique ways.
The return on equity is one statistic among several in a financial study, but it only shows a small slice of the whole financial picture. When assessing a company's financial health, it's essential to use multiple criteria.
