What is the Return on Equity? 

The Return on Equity (RoE) is a measure of the profitability of a business concerning the funds by its stockholders/shareholders. ROE is a metric used generally to determine how well the company utilizes its funds provided by the equity shareholders. 

For example, if a company has a RoE of $1, it means $1 of the investor’s funds generates a net income of $1. This metric helps the investor know how efficiently the company is using its funds.  
 
For Investors, the higher the RoE the better, however, it is important to read the RoE in light of a lot of factors to avoid wrong decisions. In this write up we will get a better understanding of the formula and factors that affect the RoE. 

The Return on Equity (RoE) is also known as Return on Capital Employed (ROCE) or Return on Invested Capital (ROIC). 

Another concept used to measure profitability is RoA or Return on average assets of the Company. It shows how well the assets of the company are earning for the Company. 

The Formula for Return on Equity

Return on Equity is calculated by dividing Net income in the Income statement by average shareholders’ equity in the Balance Sheet. 

$\text{Return on Equity}=\frac{\text{Net Income}}{\text{Average Sharholders' Equity}}$

•   Net income is the amount of income, net of expense, and taxes that a company generates for a given period. 

$\text{Net Income}=\text{Revenue}-\text{Expenses}-\text{Taxes}$

• Shareholder’s Equity or Shareholders funds = Total Assets Less Total Liabilities or Net-worth or Total Equity capital + Retained earnings 

(Retained Earnings-Profits earned by the company post the dividend and other pay-outs over the years.) 

While calculating the Shareholder’s equity we need to consider the arithmetic mean of two period ends to arrive at an average number. 

Typically, the average is arrived at by dividing the shareholders' equity for the periods involved and dividing it by 2. 

$\text{Average Shareholders' Equity}=\frac{\text{Shareholders' Equity at Beginning}+\text{Shareholders' Equity at End}}{2}$

Example 

Calculate RoE of a company whose financials are as under 

• Net profit for the year 2020 is $1,000 
• Shareholder’s equity is $ 5,000 as of 31^st Dec 2019 
• Shareholder’s equity is $ 6,000 as of 31^st Dec 2020 

The calculation is as under 

First, we calculate the average shareholders’ equity: 

$\begin{array}{c}\text{Average Shareholders' Equity}=\frac{{\text{Shareholders' Equity at 31}}^{\text{st}}\text{ Dec 2019}+{\text{Shareholders' Equity at 31}}^{\text{st}}\text{ Dec 2020}}{2}\\ =\frac{\$5,000+\$6,000}{2}\\ =\$5,500\end{array}$

After that, we compute RoE: 

$\begin{array}{c}\text{Return on Equity}=\frac{\text{Net Income}}{\text{Average Sharholders' Equity}}\\ =\frac{\$1,000}{\$5,500}\\ =18.18\%\end{array}$

Hence, the RoE is 18.18% 

The reason average shareholders' equity is used is that this figure keeps fluctuating during the accounting period in question. Hence to arrive at a middle number that would represent the correct picture of the Shareholder’s equity for a period we use the arithmetic mean formula. 

Factors Affecting RoE 

Although RoE is used as a measure of effective utilization of equity some factors affect the RoE and while making investment decisions one is required to factor in these to determine the effectiveness of this measure. 

Following are the factors to be considered while understanding the RoE: 

• Dividend Pay-out: When a company pays dividends to its shareholders out of its profits its the net income reduces. Thus, the numerator reduces accordingly dropping the RoE. 
• When Company buys back shares: The growth rate will be lower if earnings are used to buy back shares. 
• If the Company is financed by debt more than equity. It is important to see the Debt-to-Equity ratio. 
• A company having negative earnings. 

Accordingly, while comparing the RoE of two Companies it is important to know the above factors before making any decisions. 

• To compare a company’s performance against the industry benchmark. 
• To compare the performance against the Company’s peers. 
• ROE is also a factor in stock valuation, in association with other financial ratios. 
• This can be used as a benchmark to pick stocks within the same sector only. Across sectors, profit and income levels vary significantly. 

Reasons for Variations in RoEs of the Company/Limitations involved in the use of the Formula 

Huge variation in year-on-year profits or Company capital structure not having sustainable growth rate

If a company is consistently showing losses for several years, the retained earnings show a negative number which reduces the shareholder’s equity thus reducing the denominator of our RoE formula. In case the company makes huge profits in a year it will show very good RoE for that year, although it isn’t the correct picture of the Company’s finances. 

Higher Debt 

If by the company’s financial ratios, its business using more borrowings than equity then the Company will always show a higher RoE as compared to companies with lower borrowings.  

Negative retained earnings or Negative Net Income  

RoE should never be calculated in such a scenario since it gives a very wrong picture of the Company’s finances. If a Company is showing very high RoE or very low RoE the finances of the Company could be unstable.  

Common Mistakes 

• Not considering the taxes and bad debt provision while calculating the net income 
•  Not considering the retained earnings while calculating shareholder’s equity 
•  Not annualizing the formula while calculating the quarterly or monthly RoE 
•  Comparing two Company’s RoE without understanding whether it is funded by borrowings or equity 
•  Comparing two Company’s RoE without understanding whether it paid a dividend or if it has varying profits each year 

Context and Application 

This topic is significant in the professional exams for both undergraduate and graduate courses especially following: 

• B. Com Banking and Finance 
• Chartered Accountancy: Financial Management 
• CIMA (Management Accounting) 
• MBA 
•   CFP 
• CFA 
•  CPA