Return on equity: Meaning, Criticisms & Real-World Uses

What Is Return on Equity?

Return on equity (ROE) is a financial ratio that measures a company's profitability in relation to the equity invested by its shareholders. As a key metric within the broader category of financial ratios, ROE indicates how effectively a company is using its shareholders' investments to generate net income. It is a vital tool within financial analysis for assessing a company's operational efficiency and its ability to create value for its equity investors. A higher return on equity generally signifies that a company is more efficient at converting equity financing into profits.

History and Origin

The practice of using financial ratios to evaluate business performance began to develop in the late 19th and early 20th centuries, stemming from the need for creditors and managers to assess a company's financial health and operational efficiency. While the mathematical concept of ratios dates back to Euclid's Elements around 300 B.C., their application as a specific tool for financial statement analysis emerged much later in the context of industrial maturity in the United States¹⁰, ¹¹. Early developments included the emergence of the current ratio in the 1890s, which significantly impacted financial analysis⁹.

The modern application of profitability measures, including return on equity, gained prominence as analytical techniques evolved beyond just credit assessment to encompass managerial performance. A significant milestone occurred around 1919 when the Du Pont Company pioneered a comprehensive ratio system for evaluating operating results, integrating concepts like profit margins and capital turnover to ultimately lead to a return on investment ratio⁸. This systemic approach laid foundational groundwork for various profitability metrics, including the return on equity, which became essential for evaluating how well a company generates profits from the capital provided by its owners.

Key Takeaways

Return on equity (ROE) measures how much profit a company generates for each dollar of shareholders' equity.
It is a key indicator of a company's efficiency in using equity investments to generate profits.
ROE is influenced by a company's profit margin, asset turnover, and financial leverage, as highlighted in the DuPont analysis.
While a high ROE is often desirable, it can be artificially inflated by factors like excessive debt or share buybacks, requiring careful interpretation.
ROE is a profitability ratio, providing insight into a company's ability to create value for its owners.

Formula and Calculation

The formula for Return on Equity (ROE) is:

\text{Return on Equity (ROE)} = \frac{\text{Net Income}}{\text{Shareholders' Equity}}

Where:

Net Income: Found on the company's income statement, this represents the company's profit after all expenses, including taxes and interest, have been deducted.
Shareholders' Equity: Located on the company's balance sheet, this represents the residual value of assets minus liabilities, or the capital invested by owners plus retained earnings. For a more accurate long-term view, it is common practice to use average shareholders' equity over a period, such as the average of the beginning and ending equity for the year.

Interpreting the Return on Equity

Interpreting the return on equity involves understanding what the resulting percentage means in the context of a company's industry, business model, and historical performance. A higher ROE generally indicates that the company is effective at converting the equity invested by its shareholders into profits. For example, an ROE of 15% means that for every dollar of equity, the company generated $0.15 in net income.

However, ROE should not be viewed in isolation. It is crucial to compare a company's ROE to its past performance, to competitors within the same industry, and to the industry average. A high ROE could signal a strong, efficiently run company, but it could also be influenced by a high level of debt-to-equity ratio. Companies that use a significant amount of debt to finance their operations can boost their ROE because debt reduces the amount of equity required to generate earnings. Therefore, understanding a company's overall capital structure is essential for a complete interpretation.

Hypothetical Example

Consider two hypothetical companies, Company A and Company B, operating in the same industry.

Company A:

Net Income: $1,000,000
Shareholders' Equity: $5,000,000

Calculation for Company A's ROE:

\text{ROE}_{\text{A}} = \frac{\$1,000,000}{\$5,000,000} = 0.20 \text{ or } 20\%

Company B:

Net Income: $1,200,000
Shareholders' Equity: $10,000,000

Calculation for Company B's ROE:

\text{ROE}_{\text{B}} = \frac{\$1,200,000}{\$10,000,000} = 0.12 \text{ or } 12\%

In this example, Company A has a higher return on equity (20%) compared to Company B (12%). This suggests that Company A is generating more profit for each dollar of equity invested by its shareholders, indicating potentially greater efficiency in utilizing its equity. An investor examining these figures would further investigate the underlying reasons for the difference, such as differences in profitability ratios like net profit margin or the level of financial leverage employed by each company.

Practical Applications

Return on equity is a widely used metric in various financial applications:

Investor Assessment: Investors frequently use ROE to gauge a company's efficiency in generating profits for its shareholders. A consistent and increasing ROE can be a strong signal of a healthy and well-managed company.
Performance Benchmarking: Analysts compare a company's ROE against industry averages and competitors to determine its relative performance. This helps identify industry leaders and laggards in terms of profitability from equity. Publicly traded companies are required to file detailed financial statements with regulatory bodies like the U.S. Securities and Exchange Commission (SEC), which are freely accessible through the SEC EDGAR database. This allows for thorough financial analysis and benchmarking⁷.
Management Evaluation: A company's management uses ROE as an internal performance indicator to evaluate the effectiveness of their strategies in utilizing shareholder capital. It can inform decisions related to capital allocation and operational improvements.
Credit Analysis: While liquidity ratios and solvency are primary for creditors, a strong ROE can indicate a company's overall financial health and its capacity to generate future earnings, indirectly supporting its ability to meet financial obligations. Financial ratios, including ROE, provide crucial insights into a company's financial health, used by internal and external stakeholders for various analyses such as competitor analysis, market valuation, and performance management⁶.
Valuation Models: ROE is a component in various valuation models, such as the Gordon Growth Model, which factors in a company's ability to generate returns for investors. Accessing comprehensive corporate financial data, including that found through the SEC EDGAR full text search, is vital for these analyses⁵.

Limitations and Criticisms

Despite its widespread use, return on equity has several limitations and can sometimes be a misleading indicator:

Impact of Debt: ROE can be artificially inflated by a high amount of debt. When a company takes on more debt, it reduces the amount of shareholders' equity needed to finance assets, which can mechanically boost ROE. This does not necessarily reflect improved operational performance but rather increased financial leverage and risk. Companies that fund share buybacks with debt can also experience this effect, potentially leading to a higher ROE even as financial stability decreases³, ⁴.
Share Buybacks: Aggressive share buybacks, particularly when funded by debt, can significantly reduce the denominator (shareholders' equity) in the ROE formula, leading to an inflated ROE. This can make a company appear more profitable on an equity basis without a corresponding increase in actual net income from operations. Over the long term, extensive buybacks can even lead to negative shareholders' equity, rendering ROE meaningless as a performance metric and potentially signaling financial challenges².
Negative Equity: If a company has negative shareholders' equity (e.g., due to accumulated losses or aggressive share buybacks), the ROE calculation will yield a negative or undefined result, making it difficult to interpret. In such cases, other metrics, like return on assets (ROA) based on operating income, may offer better insights into management effectiveness¹.
One-Time Events: ROE can be significantly skewed by one-time gains or losses that impact net income, making it appear unusually high or low for a particular period.
Industry Specifics: Comparing ROE across different industries can be misleading due to varying capital structures and business models. What is considered a good ROE in one industry might be poor in another.

Return on Equity vs. Return on Assets

Return on equity (ROE) and return on assets (ROA) are both important profitability ratios, but they measure different aspects of a company's efficiency. The primary distinction lies in what part of the company's funding they consider.

Return on Equity (ROE) focuses on the return generated for the shareholders. It indicates how much profit a company makes for each dollar of equity invested. This metric is particularly relevant to equity investors, as it directly reflects the return on their specific investment. It also implicitly considers the company's financial leverage, as the amount of equity is affected by the level of debt.
Return on Assets (ROA), on the other hand, measures how efficiently a company uses all of its assets (financed by both debt and equity) to generate profit. It reflects the overall operational efficiency of the business, regardless of its capital structure. ROA is useful for comparing companies with different levels of debt because it eliminates the effect of financing decisions.

Confusion often arises because both ratios use net income in the numerator. However, ROE uses shareholders' equity in the denominator, while ROA uses total assets. A company can have a high ROE but a low ROA if it carries a significant amount of debt, as the debt reduces the equity base, thereby amplifying the return on that smaller equity base. For a holistic view, analysts often consider both ratios together, sometimes even breaking them down further using the DuPont analysis framework.

FAQs

What is a good Return on Equity?

There isn't a universally "good" return on equity, as it varies significantly by industry. However, a general rule of thumb is that an ROE consistently above 15-20% is often considered strong, indicating that a company is generating good profits for its shareholders. It's crucial to compare a company's ROE to its historical performance and to its peers within the same industry to determine if it is performing well.

Can Return on Equity be negative?

Yes, return on equity can be negative. This occurs when a company has a net income that is negative (a net loss), or when its shareholders' equity becomes negative (which can happen due to sustained losses or aggressive share buybacks exceeding retained earnings). A negative ROE indicates that the company is losing money relative to the equity invested, or that its equity base has been eroded.

How does debt affect Return on Equity?

Debt can significantly impact return on equity. When a company uses more debt to finance its assets, the amount of shareholders' equity required decreases. Assuming net income remains constant or increases proportionally, this reduction in the denominator (equity) will increase the ROE. This is known as financial leverage. While leverage can boost ROE, it also increases financial risk, as the company takes on more obligations to creditors