ROE, meaning and calculation of the Return on Equity

The Return on Equity (ROE) is one of the main and most important balance sheet indicators to know in-depth since it indicates the profitability of a company. This index is inserted among the various balance sheet indices to evaluate the quality of a company, alongside others such as the ROI (Return on Investment), the ROA (Return on Asset), or the ROS (Return on Sales).

Among all these, the ROE is the best representative of the profitability of a company, which will however be best assessed only through the combined use of multiple indicators. It must always be interpreted in the context of the sector and the company’s strategy.

When looking for a company to invest in, it is good to evaluate which companies can create profit and which instead tend to destroy it. ROE is the ideal tool for evaluating the best investment in terms of profitability, also allowing you to compare different realities belonging to the same sector.

Let’s try to understand, therefore, what ROE is, how it is calculated and how it is used to choose the investment with the best earnings prospects.

ROE: meaning and definition of Return on Equity

The Return on Equity (ROE), indicates how much a company can generate in terms of profit with the capital invested by its shareholders. It is an essential tool for investors, financial analysts, and company managers, as it helps to evaluate the efficiency with which a company uses its funds to produce profits.

From a technical point of view, ROE is a ratio that relates a company’s net profit to its shareholders’ equity. Equity represents the funds invested by shareholders and includes shareholder capital, reserves, and retained earnings.

A high ROE suggests that the company is making good use of its shareholders’ capital, while a low ROE may indicate inefficiencies or difficulty generating profits.

This metric is very useful for comparing similar companies within the same industry. However, comparing ROE across industries can be misleading, as some industries tend to have different capital structures and different profit margins. For this reason, it is important to always consider ROE in the context of the industry and the company’s strategy.

What does ROE mean and what is it used for?

ROE is not just a simple mathematical formula, but is also a key indicator of a company’s financial health. Let’s take a closer look at what it represents and what it is used for.

• Efficiency in managing capital: ROE measures how much profit is generated for each unit of equity invested. If a company has a high ROE, it means that it is using shareholders’ money effectively to generate profits. On the other hand, a low ROE may suggest that the company is not making the best use of its resources.
• Attractiveness to investors: Investors are always looking for companies that can provide adequate returns. A high ROE makes a company more attractive because it indicates that there is the possibility of earning good returns on invested capital. It also helps to understand how stable a company is in the long term, as a consistently positive ROE shows that the company knows how to generate profits sustainably.
• Company comparison: ROE is particularly useful when it comes to comparing different companies in the same industry. This is because similar companies operate in comparable market environments and with comparable capital structures. By comparing ROE, you can identify which company is more efficient at generating profits than its competitors.
• Indicator of growth potential: A high ROE often suggests potential for future growth. When a company can make good profits using little capital, it can reinvest those profits in new projects, expansions, or innovations. Therefore, a high ROE could indicate solid and sustainable future growth.

Compared to other indicators, ROE is the one that directly takes into account what the investor is most interested in knowing in terms of a potential investment: profitability.

How to calculate ROE: the formulas you need to know

Calculating ROE is relatively simple and only requires a few data from a company’s balance sheet. This index indicates in percentage how much profit has been generated based on the money invested in the capital, according to the following formula:

ROE = (Net Operating Income / Equity) x 100

The result - as can be seen - demonstrates the efficiency with which the company generates profit and represents it through a percentage number, useful for making direct comparisons with other rivals in the same sector.

There are also two other ways to calculate ROE, according to the following formulas:

• ROE = ROI x Leverage x IGNC
• ROE = ROA x ME

Let’s now interpret the result obtained from the ROE calculation.

How is ROE used?

The percentage value obtained with the ROE calculation is not useful if considered independently, but must be compared and analyzed relatively.

The most immediate comparison is between two companies in the same sector, where you want to understand which is the best generator of profit.
However, to judge a single company, it is necessary to evaluate the risk premium.

The risk premium is the difference between the ROE and the return offered by so-called risk-free investments, such as government bonds. Investing in a company rather than freeing oneself in a haven must provide a premium, an extra return.

The higher the risk premium, the better the investment in that company, and it all stems from the consideration of the ROE. Furthermore, the Return on Equity is based on the intrinsic link between the profit of a company and the return that its investor gets from it.

A reality that generates profits is, in fact, a reality that manages to operate with a competitive advantage compared to its rivals. The best results and, therefore, the profits achieved compared to the means employed, or ROE, are an essential evaluation for choosing the best investment.

ROE Analysis: Some Examples to Understand

Let’s now look at some practical examples to better clarify the importance and functioning of ROE.

• Example of High ROE: Let’s imagine two companies in the same sector. Company A has an ROE of 25%, while Company B has an ROE of 10%. This suggests that Company A is much more efficient in generating profits with the invested capital. Investors may prefer Company A since it seems to have a higher return.
• Example of Low ROE: If a company has a ROE of 5%, it could be a warning sign. It can indicate that the company is not making the best use of its capital or that it is struggling to generate profits. However, it is important to consider the context: some industries tend to have lower ROEs by nature, such as utilities, which require huge investments in infrastructure.
• Negative ROE: A negative ROE indicates that the company has recorded a net loss. This is generally a sign of financial difficulty, especially if it persists over time. Investors should investigate further to understand whether this is a temporary phase or a structural problem.

The Limits of ROE

When evaluating a company using ROE, in addition to including other financial indicators in the process that are useful for having a more complete picture, it is good to be clear about the two main limitations of ROE.

The first concerns devaluations

• If a company carries out a devaluation, the (negative) variation in earnings will only occur in the following period, while the denominator of the calculation formula will decrease, leading to a higher ROE calculation, but not including the devaluation that occurred. The same argument also applies to buyback operations.

The second instead looks at debt

• A high ROE does not indicate whether the company is making profits thanks to a high degree of debt or only with the support of its own means and its shareholders. An increase in debt causes an increase in ROE, but the condition through which this occurs may be anything but ideal. Original article published on Money.it Italy 2024-10-21 18:17:38. Original title: ROE, significato e calcolo del Return on Equity