There are plenty of financial metrics that a CFO can have on their dashboard, from annual revenue to net profit margin. But when working with investors, there’s another to add to the mix: Return on Equity.
Return on Equity (ROE) speaks to how effectively your company generates profit from its shareholders’ investment. A higher ROE is a good sign for investors, as it demonstrates a strong ability to generate a return on their investment.
In this article, we’ll explore the importance of Return on Equity, how to calculate and interpret it, and the limitations of ROE as a financial measurement.
What is Return on Equity (ROE)?
Return on Equity (ROE) is a financial metric that measures your company’s profitability relative to shareholder’s equity.
ROE is expressed as a percentage. If you have an ROE of 30%, it means that for every $1 of shareholder equity, your business generates $0.30.
Naturally, higher ROEs are better than lower ROEs. A higher ROE suggests that your company is efficiently using shareholder capital to generate profits, while a lower figure might indicate inefficiencies.
The importance of ROE in financial analysis
ROE is a key metric in financial analysis. It helps investors assess a company's ability to generate returns on their investment. Here’s why it matters:
1. Indicator of profitability and efficiency
A consistently high ROE is an indicator of strong management and operational efficiency, something that investors value highly.
2. Evaluating shareholder value creation
ROE can be considered a direct reflection of the return shareholders receive on their investment. Businesses that have higher ROEs tend to provide better long-term value to investors.
3. Comparison across companies and industries
ROE is a helpful metric for comparing companies within the same industry to identify which is most efficient and profitable.
Of course, when making investment decisions such as these, wise investors combine ROE alongside other metrics to get a complete picture.
Companies can artificially boost ROE by increasing debt, which reduces shareholders’ equity. This is why investors must also assess the company’s financial leverage to ensure the high ROE is sustainable.
4. Growth potential and reinvestment decisions
A company with a high ROE and strong reinvestment strategies is more likely to experience sustainable growth. Investors often look at ROE alongside the company’s reinvestment rate to assess future earnings potential.
How to calculate Return on Equity (ROE)
Return on Equity formula
Here’s the ROE formula:
It’s made up of two basic components:
- Net income: The company’s total earnings for the period after subtracting all expenses, taxes, and interest. It is found on the income statement.
- Shareholders’ equity: The net worth of the company, calculated as total assets minus total liabilities. It is found on the balance sheet.
A step-by-step guide to calculating ROE
Here’s how to use the above formula to calculate ROE:
- First, find your net income for the period on the income statement.
- Second, look for shareholders’ equity on the balance sheet for the same time period.
- Then divide net income by shareholders’ equity
- Multiply that by 100
That’s your ROE, expressed as a percentage.
Let’s run through that again with an example. Say your company has the following figures:
- Net income = $500,000
- Shareholders’ equity = $2,500,000
Applying the Return on Equity formula:
($500,000 / $2,500,000) x 100 = 20%
This means that for every dollar the shareholders have invested in the company, $0.20 in revenue is generated.
Interpreting Return on Equity
So using the ROE formula gives you a percentage, but how can you use that metric to evaluate your company’s financial health, stock performance, and risk level?
Here’s how investors and analysts use Return on Equity in their financial evaluations.
Evaluating stock performance
Generally speaking, a higher ROE leads to stronger stock performance.
Inventors see the efficient use of equity as a positive sign, making the company a more attractive investment. They buy more, and the stock price increases.
Comparing similar companies in the same industry is important here.
Evaluating risk
Stable ROEs are preferable. If a company’s ROE fluctuates, it can indicate volatile earnings, poor financial management, or strong external market pressures.
High ROE can be a good thing, but if it's coupled with high debt it can be a sign of risk. Increasing debt artificially inflates ROE by reducing shareholder’s equity.
A negative ROE is an even bigger warning sign, indicating that the company is operating at a loss.
Evaluating company performance over time
If ROE is steadily increasing, this can be an indication the company leadership is impacting positive change in efficiency.
A consistently strong ROE is also a good sign. What investors generally see as a negative indicator is if ROE is declining. This can suggest declining revenues, rising costs, or increased shareholder equity due to excessive dilution.
How ROE informs investment decisions
Investors use ROE to:
- Identify profitable companies with strong shareholder returns.
- Compare companies within an industry to find those with a competitive edge.
- Spot red flags such as excessive debt or declining profitability.
- Assess long-term growth potential, especially when paired with reinvestment strategies (e.g., high ROE companies that reinvest profits effectively may experience strong growth).
Limitations of Return on Equity
While ROE is a valuable metric for assessing profitability and efficiency, it can be misleading, especially if taken at face value without considering other essential measurements.
Impact of leverage on ROE results
Leverage (debt) can play a huge role in shaping ROE calculation.
When a company takes on more debt, it dilutes shareholders’ equity by increasing liabilities. This has the effect of increasing Return on Equity, distorting the ratio.
A high ROE driven by debt rather than operational efficiency can be risky since this increases interest expenses and financial instability. When considering ROE as a measurement of financial health, investors should look at how the company is leveraged.
The impact of leverage on ROE also makes comparing similar companies complicated.
A company that operates without debt might have a lower ROE than one with more debt, not because they are less efficient, but because they have a larger equity base. Investors should be careful not to rely too heavily on ROE when comparing companies with different debt levels.
Other situations where ROE may be misleading
Beyond leveraging considerations, there are a few important situations in which ROE as a sole metric can mislead investors. These include:
- If a company has very low or negative equity (e.g., due to accumulated losses), its ROE can be inflated or meaningless.
- If a company temporarily boosts net income through asset sales, tax benefits, or accounting changes, this can temporarily inflate ROE, misleading investors (who don’t pay attention to trends) about long-term profitability.
- If a company buys back its own shares, it reduces shareholders' equity, causing ROE to artificially rise even if profits remain unchanged.
It’s also important to note that ROE doesn’t speak to a company's growth potential.
A business might have a high ROE but limited reinvestment opportunities (e.g., it has already saturated its market), in which case future growth would be restricted.
Return on Equity shouldn’t be viewed in a vacuum
Return on Equity (ROE) is an important financial metric that helps investors and analysts gauge a company’s profitability and efficiency in generating returns from shareholder investments.
Like most financial metrics, it shouldn’t be assessed in a vacuum. Instead, investors should look at other financial indicators and consider the company’s debt exposure to build a better picture of the company’s financial strength.
Looking to improve your own ROE? BILL’s integrated financial operations platform is packed with features to help you monitor and cut costs, drive revenue, and improve reporting efficiency.
Frequently Asked Questions about Return on Equity
What’s the difference between ROE, ROA, and ROIC?
ROE, ROA, and ROIC are three important but different financial metrics:
- Return on Equity (ROE) measures profitability relative to shareholder’s equity
- Return on Assets (ROA) measures profitability relative to total assets
- Return on Invested Capital (ROIC) measures profitability relative to total invested capital (debt and equity combined)
What does Return on Equity tell you?
ROE tells you how effectively a company is using shareholders’ equity to generate profits.
A high ROE (15-20%) indicates strong profitability and efficient capital use, while a lower ROE (below 10%) may highlight poor profitability, inefficient, or high equity levels.
Changes and trends in ROE are important to monitor as well. Stability is generally desirable, and declining ROE can signal deteriorating business performance or rising costs.
What is ROE and why is it important?
ROE (Return on Equity) is a financial ratio that measures how much profit a company generates for every dollar of shareholders’ equity.
It's important because it helps investors compare companies in similar industries, assessing their management efficiency, profitability, and long-term growth potential as part of their ratio analysis.
What is a good ROE ratio?
A good ROE ratio depends on your industry. Tech and software companies tend to have higher ROEs due to their use of asset-light models while manufacturing companies have lower ROEs due to high capital investments.
On average, however:
- 15-20% is generally considered strong
- 10-15% is acceptable
- 10% or lower may be a red flag
