Return on equity

Key Takeaways

1. Return on equity or RoE is the income earned by a company on its equity capital.
2. RoE is one of the essential tools available to measure a company’s performance and management efficiency.
3. It shows us how the company is genuinely performing despite the performance of the stock.

Return on equity or RoE is the income earned by a company on its equity capital.

RoE is measured by dividing the net income of the company with the equity share capital or the average shareholders’ equity.

RoE Formula/ratio/interpretation / Below is the formula for calculating RoE:-

The average shareholders’ equity is the simple average of opening equity share capital and closing equity share capital.

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RoE is a financial ratio that can be used to compare a company with its peers in order to determine which of them is the better investment option.

Why is ROE Important?

RoE is one of the essential tools available to measure a company’s performance and management efficiency. RoE tells us about how much profit a company generates on shareholders’ equity. It only weighs a company’s performance, not stock performance. Return on equity shows how the business is growing, how efficiently the company is utilizing its assets. If the profit increases without any additional assets and the debts, it means a company is using its assets efficiently. If the liabilities increase, but the profit and assets remain constant, that means the denominator decreases; the numerator is the same; in this case, return on equity also increases. This result does not indicate any real improvement in efficiency. In this case, RoE does not mean any growth or profitability. Focus is on the long run.

Return on Equity is a good test to see if a company is growing amongst its peers at a respectable rate. It shows us how the company is genuinely performing despite the performance of the stock.

Pros and cons of RoE

One way to increase the RoE of the company is by repurchasing its shares. The buyback of the stocks reduces the total equity of the company. In this scenario, denominator reduces, and if profit remains the same, RoE will increase. But this does not mean that the company’s performance has improved.

Higher RoE is advantageous to the business. However, a company faces a greater risk than its rivals if it has grown the amount of its debt. A higher debt results in a lower equity value overall, which raises ROE. Higher debts mean higher expenses, and higher payments lower the profit of the company.

RoE helps investors to analyze company performance and performance of various equity investments and to develop strategies for future investment. It shows how well a company utilizes shareholder’s funds.