Meaning of Return on equity (ROE)- After Tax
It is the net income that the company receives after income taxes divided by the average amount of shareholders' equity during the period of the net income. It measures the profitability of a company with respect to stockholders’ equity. The ROE must be compared to the historical ROE of the company and the industry’s ROE average in order to get a complete picture and must not be looked at in isolation.
Calculation of Return on Equity
- ROE = Net Income/Average Shareholder’s Equity
- Where,
- Net Income is the amount of income, net of expenses and taxes that a company generates for a given period.
- Average shareholders' equity is calculated by adding equity at the beginning of the period.
- It can also be calculated using Dupont formula.
Uses of ROE
- It can be used as a metric by the company to see how efficiently they are utilising their equity.
- Dividend growth rates can be estimated with the help of ROE (assuming that it is in line with/just above its peer group). It is estimated with the help of multiplying the ROE with the payout ratio.
- It is a good way to estimate the stock’s growth rate and the company’s future growth. It is measured as the product of the ROE and the company’s retention ratio.
- The ROE can be used to identify risks and problems. For instance, a very high ROE indicates risk, as the company has a small equity amount in comparison to its net income. It could also indicate that the company has inconsistent profits or excess debt or a negative net income.
Drawbacks of ROE
- The ratio can be skewed by share buybacks.
- The ratio may exclude the intangible assets that the company owns such as goodwill, patents and other intellectual property.
- The composition of the ratio is subject to variations such as the shareholders’ equity can either be the beginning number, ending number, or the average of the two.
ROE and Return on Invested Capital (ROIC)
ROE looks at how well a company uses its shareholder equity while ROIC determines how well the company uses all its available capital to make money (which includes both equity and debt).
ROE and Return on Assets (ROA)
ROE compares net income to the net assets of the company, whereas ROA compares net income to the company’s assets alone, without making any deductions of its liabilities.
