ROE is a crucial metric for evaluating a company's profitability. This guide provides a clear explanation of ROE, including its formula, interpretation, and limitations. Learn how to use ROE effectively, alongside other metrics like ROA, to make informed investment decisions.
ROE, or Return on Equity, is a key financial metric that indicates how efficiently a company generates profit using its shareholders' equity.
In this article, we will provide detailed explanations of ROE, including its meaning, formula, and specific examples.
What is Return on Equity (ROE)?
This blog by OANDA explains the meaning, formula, and specific examples of ROE.
What does return on equity mean?
ROE is a financial metric that indicates how efficiently a company generates profit using its shareholders' equity (the capital invested by shareholders and retained earnings).
Generally, a higher ROE suggests that a company is efficiently generating profit, whereas a lower ROE indicates inefficiency.
How is return on equity calculated?
The formula for calculating ROE is shown below.
ROE is determined by measuring the proportion of net profit (from the Profit and Loss Statement, PL) relative to shareholders' equity (from the Balance Sheet, BS).
For example, if a company has shareholders' equity of 5 million dollars and a net profit of 1 million dollars, ROE is calculated as follows:
What does ROE reveal?
ROE reflects the efficiency of a company's management.
For shareholders, it functions similarly to an investment return indicator, allowing them to assess changes in investment value by comparing trends over time.
However, a high ROE does not always indicate a healthy financial state. It is important to consider other financial factors alongside ROE when evaluating a company.
Points to consider about ROE
There are two key points to keep in mind when evaluating ROE:
1. ROE does not account for debt
As mentioned earlier, ROE is calculated using shareholders' equity as the denominator, meaning it does not take debt (borrowed capital) into account.
Since debt represents funds that must be repaid, a company with high debt levels may not have a healthy financial position, even if its ROE appears strong.
To get a broader perspective, if you replace shareholders' equity with total assets (shareholders' equity + debt) in the denominator, you can calculate ROA (Return on Assets), which provides a more comprehensive view of a company's profitability.
2. ROE should not be evaluated in isolation
ROE alone does not provide a complete picture of a company's financial health. It is better to use it alongside other financial metrics.
By combining ROE with indicators like ROA (Return on Assets) and debt ratio, investors can better assess a company's overall financial stability and profitability.
