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In this article, we’ll talk about the Return on Equity (ROE), one of the key indicators of investment returns, which helps to assess the financial stability and investment attractiveness of different companies.
What is the ROE for?
The Return on Equity is an indicator that assesses how effective the funds invested by companies’ shareholders are. As a matter of fact, the ROE is the company’s annual profit after taxes, fees, and other statutory expenses, divided by the cost of all funds invested by its founders and shareholders without borrowed money.
As a rule, investors prefer companies and firms with a higher ROE. However, profits and incomes in different sectors of the economy vary a lot. For example, the indicator may differ even within the same sector if a company decides to pay dividends instead of keeping profits as available cash assets.
It’s important to assess the ROE in real-time mode, for a particular period of time (for example, 5 years). Investors usually calculate the ROE at the beginning and the end of their investment period, so that they could see real changes in profitability. This method gives the opportunity to assess the growth dynamics and compare the results with other companies’ performance.
A stable and eventually growing ROE attract investors. The ROE growth means that the chosen company is reliable and can produce stable income because it knows how to wisely employ its capital in order to increase performance and profits. On the other hand, the ROE decline may indicate that the company’s management makes wrong decisions and invests money in non-profitable assets.
The ROE normal value
The ROE shows shareholders how their invested funds work: how much net profit was generated by each unit of the owned capital; hence one can definitely say the following about the ROE:
- The higher the indicator, the more profitable investments in some particular business.
- If the ROE is lower than the average value in the sector, investments in this company will be rather doubtful.
On average, the ROE normal value in advanced economies is about 10-12%. In countries with higher inflation, the indicator should be higher as well, about 20-30%. To assess investment attractiveness, one can compare the ROE of the chosen company with investments in such instruments as bonds or deposits. The higher the ROE, the more attractive the company for investors.
For example, a company with an ROE twice as much as the bank deposit rate will be very interesting for investors. When investing, Warren Buffett pays a lot of attention to this indicator. In his opinion, a company with a high ROE and a small loan debt has excellent investment prospects.
Formula to calculate the ROE
There are two methods for calculating the ROE, a conventional way using total results and the DuPont analysis
Calculation of total results
In this case, the ROE is calculated as the ratio between the company’s net profit and the average shareholders’ equity:
ROE = Net income / the average shareholders’ equity *100%
The DuPont formula
Calculation using the DuPont formula allows to analyze the ROE as well. By means of additional variables, one can analyze what exact factors influence the indicator to change:
ROE = Net Profit Margin * AT * EM *100%, where:
- Net Profit Margin = Net Income / Revenue
- AT (Asset turnover) = Sales / Average Total Assets
- EM (Equity multiplier) = Average total assets / Average Shareholders’ equity.
As a result, the DuPont formula shows three factors that influence the ROE:
- Net profit margin is used as an indicator of the company’s operating performance.
- Asset turnover shows the value of a company's sales or revenues relative to the value of its assets.
- Equity multiplier measures the ratio between average total assets and average shareholders’ equity.
The purpose of using the DuPont analysis here is not only calculating the ROE but also estimating the possible impact of the above-mentioned factors on its value. It helps to determine the cause of encountered problems and take appropriate steps to eliminate them.
Example of the ROE calculation
For example, the company’s net income at year-end is $100,000$. At the same time, the average shareholders’ equity consists of 50,000 shares worth $5 each. In this case, the ROE will be calculated as follows:
ROE = 100,000 / 50,000 * 5 * 100% = 40%
It’s a high ROE, which says that the company is actively developing. For a more detailed estimate, it will be better to analyze the average ROE dynamics over 3-5 years – it will provide a fair insight into the company’s prospects.
However, one should remember that even if the OE is growing, the company’s profit is not necessarily paid to investors. If the company decides to keep its profits without paying dividends, shareholders may get profit only indirectly, due to the rise of the company’s share price.
The ROE indicator helps to assess the financial performance and investment attractiveness of any given company. As a rule, the ROE is used for comparing different companies in the same sector. Changes in the ROE dynamics are constantly analyzed by both company managers and investors for estimating the company’s profits and sustainability.