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What Is Return on Equity Ratio?
The Return on Equity (ROE) Ratio measures the rate of return on the Shareholders equity of the company. With the Return on Equity Ratio you can compare the profitability of a company with another company in the same industry.
How to calculate the Return on Equity Ratio?
Return on Equity = Net Income / Shareholders Equity
Return on Equity
It is a ratio used to compare the net income and stockholders’ equity of an organization. It measures the profitability of company with respect to the owners’ equity. It shows that how much profit is generated by company with the money stockholders invested. With the ROE you can compare the profitability of a company to its past as well as to the other company in the same industry.
Stockholders equity is = total assets – total liabilities. Stockholder equity comprises of from two main sources; first is the money that originally invested, and the second is retained earnings.
There are different variations in the formula and investors may use according to what they are measuring.
If the company also has preferred stock in its equity portion, the investors who to measure the return on just common equity can change the formula by subtracting the preferred dividends not paid to common stockholders. Then formula will be like; net income – preferred dividend / common equity.
If the stockholders equity is changed during the year, average stockholders’ equity can be used to measure the ROE for the year. The average stockholders’ equity is calculated as:
Stockholders equity at beginning + stockholders equity at end of the period/2
If new stocks are issued, then it is better to use the weighted averages of numbers of stocks throughout the year but it would be a complex task.
Return on Equity and DuPont system:
ROE can also be finding out by using DuPont model. There are three components of ROE by using traditional DuPont model; Net profit margin, Assets turnover and Equity multiplier. By calculating the each component individually we can discover sources of companies ROE to compare it to other companies in the industry. This will help the financial analyst to examine individual components and better finding the areas which lack.
Significance of ROE:
ROE is an important measure of company’s earnings performance. It shows the stockholders and new investors that how efficiently the organization is using their funds to generate financial gains. It also can be regarded as an ultimate ratio or “mother of all ratios”. It provides a good analysis of profitability of the company over the time as well as helps in comparing the company with other companies in the same industry. Return on equity ratio in the range of 15 – 20 % is good. It can be higher for the companies growing with a higher pace.
But, it is not an absolute measure of investment as when the stockholders equity value lowers, it goes up. Although, high ROE ratio is good, but it doesn’t shows always that financial performance is good.