Return on equity formula: what it is and how to use it

If you work with an organization’s financial data, you can evaluate the information to determine whether the company is using its money efficiently. One way to analyze this is with return on equity (ROE), which tells you how effective a company is at turning shareholder investment into profit. Learning how to use the formula to determine a company’s ROE can help you make more logical decisions about investment opportunities. In this article, we discuss the return on equity formula, the importance of calculating a company’s ROE and how to use the formula, and we provide an example calculation.

What is the formula for return on equity?

The return on equity formula is a calculation that takes net income and divides it by the average equity balance in the previous and current periods. The result of an ROE calculation is a percentage, and it can tell you how well the company is managing financial contributions from its shareholders. The equation looks like this: Return on Equity = Net Profit / Average Equity Ideal ROE percentages vary depending on the industry or sector in which the company operates. For example, utilities often have a lot of liabilities and assets on their balance sheets compared to a relatively small net profit. An ideal ROE in the energy sector might be 10% or less, while a retail or technology company with a smaller balance sheet to net profit ratio might have normal ROE levels of 18% or more.

Advantages of calculating ROE

Return on equity allows you to calculate other figures that predict potential growth and strategic investments, among others, for a company. For example, you can use ROE to estimate: – Sustainable growth rate: This allows you to evaluate companies that have the same ROE and net income but different retention ratios or retained earnings. By multiplying the ROE by the retention ratio, you can determine which of these companies has a more sustainable growth rate over an estimated period. – Dividend growth rate: This refers to a stock’s dividend growth over a period. Multiplying the ROE by the company’s payout ratio gives the dividend growth rate. You can also use ROE to identify potential problems in a company’s financial profile. For example, an unusually high ROE could signal that a company has excessive debt or inconsistent profits. It could mean that your ROE calculation used negative numbers, which it shouldn’t, so try to double-check your formula for accuracy.

What does a high ROE mean?

You can use ROE as a measurement tool while identifying a company’s investment value, and a higher ROE can mean that a company has:

Improved profit retention

A company with a high ROE is often good at retained earnings, which is a company’s cumulative net profit or earnings after accounting for dividends. These earnings give companies access to a larger pool of capital. When a company maintains its earnings and uses them as working capital, it may not need additional debt and can avoid interest expense. If a company is making a profit and has a growing ROE, it could mean successful profit generation from retained earnings.

Higher ability to use shareholders’ money

Organizations with high ROE may be more capable of using shareholder money effectively. If an organization shows high ROE consistently over time, it may be a good investment. This is because profits can continue to increase due to effective money management.

More advantage over competitors

Organizations with high ROEs can gain an advantage over their competitors because they can protect their long-term profits and have a large market share. Organizations can leverage these advantages to continue generating profits in the long term. They can also reinvest their earnings for an ongoing cash flow.

How to calculate a return on equity

You can calculate the ROE of any company if both net profit and equity are positive numbers. Here are the steps you can follow to calculate a company’s ROE:

1. determine the net income

Net income is a company’s total revenue minus its operating expenses, taxes and interest. You can find information on revenue and various operating expenses on a company’s income statement. Once you have determined the annual net income you use to calculate ROE, this figure will be at the front of your equation.

2. Calculate equity

You can calculate equity in the same way as net profit. For this, you subtract the company’s total liabilities from its total assets to find the number you can use, and you can find both figures on the company’s balance sheet. The resulting figure is the second part of your ROE equation.

3. Split the two figures

Once you have your figures, divide the company’s net profit by its equity. Before performing the calculation, make sure these figures are positive so that the resulting ROE is correct. The result often contains decimals, which you can convert into a percentage if you multiply it by 100. This percentage is the company’s return on equity.

Example of calculation of return on equity

Here is an example ROE calculation: Bonus Corp’s most recent annual revenue was $5,000,000 and its annual operating expenses were $3,915,200, which means that Bonus Corp’s net income for that year was $1,084,800. Its total assets in the last fiscal year were $20,200,000, while its total liabilities were $8,900,000, so its equity for that year was $11,300,000. To calculate Bonus Corp’s return on equity, its managers divide its net profit by its equity. Here’s the equation: Return on Equity = $1,084,800 / $11,300,000 Return on Equity = 0.096 The result and Bonus Corp’s ROE is 0.096, or 9.6%. To fully interpret this ROE, Bonus Corp’s manager looks at industry trends and competitors’ ROEs. While the average S&P 500 ROE is 14%, industries can differ from this average based on the number of assets they use to generate a profit.

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