Return On Equity (ROE), also sometimes called return on net worth (RONW), is a measure of how much, as a percentage of the initial investment of a company’s shareholders, has been returned in profit. This helps us learn how efficient a company is at making profits compared to other investment options, like its industry rivals, for example. High growth companies usually have a high ROE to match, making a pleasing ROE figure in a company’s account catnip for investors!
Return on equity is calculated using the below formula, where net income is revenue for the full fiscal year, and shareholder’s equity excludes preferred shares:
ROE= Net Income (profit after tax) / Shareholder’s Equity (equity capital employed)
The end result is then expressed as a percentage, representing the difference on equity employed.
Why Is Return On Equity Important?
Return on Equity is a useful way that investors can compare businesses to invest in, based on their efficiency in making money for shareholders. For example, consider that you have two possible companies you could potentially invest in, each of which brought in £250,000 net income this year. However, while one company – let’s call it Company A – has £1,000,000 worth of shareholder equity, Company B has £2,500,000. Which is more profitable?
By applying the return on equity formula as below:
Company A: £250,000 / £1,000,000 = 0.25 = 25%
Company B: £250,000 / £2,500,000 = 0.1 = 10%
… we can discern that Company A is more profitable than Company B relative to its initial investment – it makes 25% return on equity compared to Company B’s 10%. This means Company A is more efficient than its counterpart, which, again, is what ROE really measures. How do we know Company A is a more efficient profit-making enterprise? Well, despite having had less equity – capital invested by shareholders – Company A has managed to make the same profits. It needs less to achieve more.
Efficiency is a very important metric for investors, making ROE a valuable tool in their arsenal. Securing a positive ROE is one of a firm’s major responsibilities to its shareholders. Indeed, doing so successfully is often rewarded with further capital flow into the company from other investors!
Directors of a company are often expected to promise a certain return on equity in their annual forecasts. Shrewd investors should compare the previous year’s figure to the forecasted one for the previous year before deciding to buy into an organisation. If it is available, the company’s average ROE over longer periods should also be considered, as this might give a better indication of whether a forecast is realistic.
The Downsides Of Return On Equity
However, remember that return on equity is not the only metric used to calculate the value of a potential investment! Some other important considerations include return on invested capital, earnings per share, and return on total assets. It is important to get as broad a picture of a business as possible before choosing to take the risk of investing in it. Otherwise, a lack of information may result in unexpected losses.
How so? Well, investors who rely too heavily on ROE can end up stung is because the figure doesn’t reflect the level of risk involved in a company’s financing. It is all very well and good to calculate the profitability of equity financing, but what if a company is heavily financed by debt? Take a hypothetical company which is capitalised at £1,000,000. It is funded by £60,000 equity and £940,000 debt, which must be repaid at a 4% rate of interest. Its profit after tax for the year has been £3000. Let’s first calculate the company’s ROE:
ROE = £3000 / £60,000 = 0.05 = 5%.
But, of course, shareholders won’t see all of this return on equity, because some of the figure has to be put into interest repayments for the debt that ROE formula is hiding. 4% of £940,000 is £376, meaning that the true return on equity is £3000 – £376 = £2624. Again, it must be stressed – you can never have too much information when evaluating a potential investment. Always be wary of company accountants dolling up their enterprise’s best figures in the hopes of fooling an investor who doesn’t dig beyond the surface.
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