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ROE

 

ROE (Return on Equity) shows profitability of company’s book value. Company’s book value (equity) is equal to company’s assets less liabilities, and ROE is usually higher if company has higher financial leverage (but only if the leverage is not too high). 

 

ROE is more meaningful if company’s assets are often renewed because then value of equity is closer to real market value. For example, if some utilities company have made main investments many years ago and recent investments are very low and if assets in the balance sheet wasn't revaluated recently, then ROE can be very high but it won't say anything, because now such investments should cost more in real prices of assets in balance sheet ROE would be lower.

 

High ROE means that return from the business is good and is worth to expand it investing more capital. There are many stock valuation methods that use ROE as a key factor for value determination. Companies that maintain high ROE might be evaluated much pricier than companies with low ROE, but it works only in theory. In practice high ROE is very valuable only in the cases when high ROE can be maintained from new projects and expansions of the company. If new project investment (expansion) of the high ROE company would not create high ROE as well, then value of high ROE diminishes. 

 

Average ROE in the financial markets is from 10% to 15%. If company’s ROE is significantly lower, it might mean few things:

  • Company’s management doesn’t work efficiently.
  • Competition in this market segment is very high.
  • Market segment is in downturn.
  • Company isn’t close to target capital structure.

 

ROE calculation


ROE = Net Income* / Equity**


* Net income is net profit attributed to shareholders of common equity (after preferred shares dividends) of the company for last four quarters or the best choice for the last fiscal year audited results. 


** It is a book value attributed to shareholders of common shares and for calculation of ROE equity should be used as annual average.


*** You may multiple the result by 100%. 

 

(2) Non-cash ROE also can be calculated:

 

Non-Cash ROE = (Net income - Interest income * (1 - Tax rate)) / (Equity - Cash)

 

ROE is important ratio in corporate finance, however, not the only one. To measure real profitability of the company other ratios should be also calculated and compared to ratios of similar companies (competitors): ROA (Return on Assets), profit margin, EBITDA margin.

 

 

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