Return on Equity provides insight into how efficiently a company’s management is using financing from equity to operate and grow the business.
Return on Equity (ROE) is the measure of a company’s annual return (net income) divided by the value of its total shareholders’ equity. It is a simple metric for evaluating investment returns and it brings together the income statement and the balance sheet, where net income or profit is compared to the shareholders’ equity.
“ROE is a way to think about how much money you are getting back from an investment,” says Mike Bailey, director of research at FBB Capital Partners in Bethesda, Maryland
The number (ROE) represents the total return on equity capital and shows the firm’s ability to efficiently turn equity investments into profits. To put it another way, it measures the profits made for each dollar from shareholders’ equity.
It is a ratio that investors can use to compare firms operating within the same industry to assess which one presents better investment opportunities.
Comparing ROE for different companies in the same industry helps investors to see which ones have generated the highest rate of return. ROE is a useful metric for service-based businesses.
A sustainable and increasing ROE over time can mean a company is good at generating shareholder value because it knows how to reinvest its earnings wisely, so as to increase productivity and profits.
“ROE tells you how good or bad management is doing with your investment,” Bailey says. “Higher ROEs generally stem from profitable businesses that enjoy competitive advantages within a given industry.”
In contrast, a declining ROE can mean that management is making poor decisions on reinvesting capital in unproductive assets.
In short, Return on equity measure, of how efficiently a company is using shareholders’ money. Efficient companies tend to be more profitable companies, and more profitable companies tend to make better investments, investors like companies with higher ROEs.
For capital-intensive businesses that require a larger investment in assets, like those in manufacturing and telecommunications, return on invested capital (ROIC) is a more useful measure, as it takes into account their capital expenditure.
Return on Invested Capital is calculated by taking into account the cost of the investment and the returns generated. Returns are all the earnings acquired after taxes but before interest is paid. The value of an investment is calculated by subtracting all current long-term liabilities, those due within the year, from the company’s assets.
The cost of investment can either be the total amount of assets a company requires to run its business or the amount of financing from creditors or shareholders. The return is then divided by the cost of investment.
References:
- https://corporatefinanceinstitute.com/resources/knowledge/finance/what-is-return-on-equity-roe/
- https://money.usnews.com/investing/articles/what-is-return-on-equity-the-ultimate-guide-to-roe
- https://capital.com/return-on-equity-roe-definition