What is the return on equity (ROE) ratio and why is it useful?

Revolut Contributor

· 07/06/2020  · 07/06/2020

The return on equity (ROE) is a ratio which indicates how efficiently a business creates net profits, per pound of shareholder equity. The ROE is an insightful metric, but it’s more useful for investors rather than for the business itself. This is because the ratio demonstrates the return on the money that the investors have put in. A credible ROE will help the business to persuade its existing investors to pump in more cash or to convince new ones to buy shares.

What does the ROE ratio tell us?

Profitability ratios reveal insights about the financial health of a business, relative to a specific variable for a given period. The ROE falls into the sub-category of return ratio because it uses elements from the balance sheet of the business as well as the income statement to calculate how effectively it generates a return for shareholders.

As its name suggests, the return on equity ratio measures profitability as a percentage of the combined total worth of all shares in the business.

How do you calculate return on equity?

The return on equity formula is simple. It’s calculated by dividing the net profit of the business for a period (typically a year) by the shareholder equity held within it during the same time. You multiply the result by one hundred to convert this ratio into a percentage.

Return on equity = (Net profit / Shareholder equity) x 100

As the value of shareholder equity fluctuates, it’s common to use the average figure for the period that the ratio covers by taking a figure for the start and the end of this timeframe.  Given that people calculate this ratio with different methods, it’s wise to check these things.  For instance, there is ambiguity in the UK over whether net profit formula should include tax.

It’s worth noting that a younger business might make a loss – in which case the ROE ratio will be negative – despite having impressive growth figures or other credible metrics.

Why is return on equity important?

A higher ROE ratio reveals how successful the business is at generating profit as a proportion of its equity. However, the figure can also reveal how effectively the business uses equity finance to fund operations and create growth. For example, investors often calculate the ROE over time (i.e at the beginning and end of a given period) to ensure the business maintains its earnings percentage trend.

There are two ways to boost ROCE: increase the level of net profit or reduce the value of shareholder equity. This is where things can get sticky.

One technical issue with ROE arises whenever a business has a disproportionate level of debt, as this reduces the value of its equity. The nature of this calculation can lead to an artificially high (or low) ROE value, even when the net profit figure is modest. This is why shareholders will look closely at the level of debt in the business alongside the ROE ratio.

What is a good return on equity percentage?

When thinking about: how do you interpret ROE, it’s a mistake to fixate on a specific target. As with all financial ratios, it’s more insightful to track the ROE against earlier periods, a forecast, or even an industry benchmark than to define a single arbitrary value as ‘good’.

There’s also a specific point to make here about ROE. While this ratio is an excellent way to gauge how well the business manages its investment overall, the relative levels of net income and investment equity can vary widely between different sectors. This flaw makes ROE a poor choice of metric to compare one business to another outside the same industry.

For all of these reasons, people typically employ ROE alongside two other return ratios – namely, the return on capital employed (ROCE) and the return on assets (RoA) – to provide a broader picture of performance. As a trio, the perspective can be a revelation.