The return on equity ratio or ROE is a profitability ratio that measures the ability of a firm to generate profits from its shareholders investments in the company. In other words, the return on equity ratio shows how much profit each rupee of common stockholders’ equity generates. So a return on 1 means that every rupee of common stockholders’ equity generates 1 rupee of net income. This is an important measurement for potential investors because they want to see how efficiently a company will use their money to generate net income.
ROE is also an indicator of how effective management is at using equity financing to fund operations and grow the company.
ROE = Net Income / Shareholders’ Equity’
ROE provides a simple metric for evaluating investment returns. By comparing a company’s ROE to the industry’s average, something may be pinpointed about the company’s competitive advantage. ROE may also provide insight into how the company management is using financing from equity to grow the business.
A sustainable and increasing ROE over time can mean a company is good at generating shareholder value because it knows how to reinvest its earnings wisely, so as to increase productivity and profits. In contrast, a declining ROE can mean that management is making poor decisions on reinvesting capital in unproductive assets.
Return on equity measures how efficiently a firm can use the money from shareholders to generate profits and grow the company. Unlike other return on investment ratios, ROE is a profitability ratio from the investor’s point of view—not the company. In other words, this ratio calculates how much money is made based on the investors’ investment in the company, not the company’s investment in assets or something else.
That being said, investors want to see a high return on equity ratio because this indicates that the company is using its investors’ funds effectively. Higher ratios are almost always better than lower ratios, but have to be compared to other companies’ ratios in the industry. Since every industry has different levels of investors and income, ROE can’t be used to compare companies outside of their industries very effectively.
Example of ROE
For example, according to Facebook’s (FB) most recent SEC filings, its net income in 2020 was about $29.15 Billion. Total stockholders’ equity was about $128.29 Billion.
Facebook’s ROE = $29.15 Billion / $128.29 Billion = 0.227 x 100 = 22.7%
That means that its annual net income is about 22.7% of its shareholders’ equity.
Limitations of Return on Equity (ROE)
A high ROE might not always be positive. An outsize ROE can be indicative of a number of issues—such as inconsistent profits or excessive debt. Also, a negative ROE due to the company having a net loss or negative shareholders’ equity cannot be used to analyse the company, nor can it be used to compare against companies with a positive ROE.