Return On Equity

The return on equity (ROE) is a measurement of how well a company is performing from the shareholder’s perspective over a period of time. They can then take that information and compare it to other companies to determine how they fare in the market. 

When evaluating return on equity, the shareholder looks at information from two places: the company’s income statement and their balance sheet. From the income statement, the shareholder would look at the company’s net income for that period of time. The “net income” is the cash flow that a company generates after their expenses.

From the balance sheet, they would look at the company’s equity. The term “equity,” is also known as shareholder equity. If a company were to pay off all debt and liquidate all assets, then the equity would be the money the company would return to the shareholders.

By calculating with these two key performance indicators, the shareholders can see how financially efficient a company is. They can determine how their investment is correlating to their competition. You can look at the numbers to compare the overall health of a company and to compare growth in certain periods of time. For example, in a 2-year-old company you can calculate for the ROE for the full 2 years. But let’s say the 3rd quarter is typically your busiest. You could calculate the 3rd quarter ROE for each year and contrast them. This could help you to see a more specific growth timeline. 

Return On Equity Formula

$$ROE = \dfrac{Net\:Income}{Shareholder's\:Equity}$$

To clarify, the ROE takes a company’s net profit and divides it by the value of the shareholder equity. Simply put, shareholder equity is the cash value of the investment to date that the company still owes back to the shareholders. 

Also, the period of time that you are measuring needs to match the period for the net income. You should be looking at the total equity due at the end of that same time period of time as well.  

It is important to note that this formula is especially helpful for companies that have tangible assets. Tangible assets are physical objects that have a specific monetary value. This could include current assets, like stocks or bonds, and long-term assets like machinery or real estate.    

The result of this calculation can be converted into a percentage to make it easier to understand in relation to other businesses in the market. If you are drawing up a comparison, it is far better to involve other companies within the same industry. Try to find companies with similar equity and a comparable business model. The results of your analysis would be far more precise. 

Return On Equity Example

Shareholders want to analyse the management of their company. The industry has an average ROE of 12%. Their company has a net income of $3,000,000. They have equity of 15,000,000. Calculate their return on equity. How does their company compare to the industry?

Let’s break it down to identify the meaning and value of the different variables in this problem. 

  • Net Income: 3,000,000
  • Shareholder Equity: 15,000,000

We can apply the values to our variables and calculate this company’s return on equity.

$$ROE = \dfrac{3{,}000{,}000}{15{,}000{,}000} = 20\%$$

In this case, the return on equity for their company would be 0.2 or 20%. 

Compared to the industry average of 12%, the shareholders can see that the company is doing significantly better than the overall industry. 

Now, the shareholders can see that the company’s management is performing at a high standard. They are efficient with managing their finances, leaving shareholders to feel confident about their investment.  

Return On Equity Analysis 

Essentially, the shareholders want to know if a company can give them a profitable return on their investment. The results of a return on equity appraisal can indicate how attractive a business might be to its shareholders. 

What’s more, the ROE can help you to assess the managerial plan of a given company. You will find the ROE to be an accurate indicator of their efficiency. A high ROE means that the company’s management is more adept at handling the finances and producing growth from the capital they’ve been given. For example, if a company has a low ROE, you might want to take a closer look at the decisions that managing employees are making. Can things be changed to produce a better ROE?

You might be wondering if it’s even possible to change the results of your ROE. You can, but it might require some difficult decisions. But these decisions could help you create a more viable business in the long term. 

If you are wanting to see a change in your ROE, you have two choices. You can either find a way to reduce the amount of equity, or you can find ways to increase your net income. This is the easier of the two options. 

To lower your equity, one option would be choosing to increase the dividends you pay to your shareholders. However, to accomplish this you would likely have to use the money you would’ve paid to employees or money you needed for growth. Another option would be to get more financing (increasing your debt to equity ratio) and use the added cash flow to bankroll growth at an accelerated rate. Both these options would involve increased risk and potential sacrifices. 

The other option would be to look at improving your net income. Some options here would include adjusting your prices, improving productivity, or making changes to your product and its quantities. Finding profitable solutions to increase your net income is a sign of the quality management that produces a high ROE rate.  

Return On Equity Conclusion

  • The return on equity measures how well a company is performing from the shareholder’s perspective over a period of time. 
  • The ROE takes a company’s net profit and divides it by the value of the shareholder equity
  • The return on equity formula includes two variables: net income and shareholder equity. 
  • A high return on equity means that the company’s management is more efficient and will produce more growth. 

Return On Equity Calculator

You can use the return on equity calculator below to quickly evaluate a company’s financial management by entering the required numbers.

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