Return on Equity – Definition, Calculation and Formula of ROE

Return on Equity or ROE is one of the vital parameters for collecting information about a company. It helps investors understand how a business allocates capital and generates a return.

What is Return on Equity?

Return on Equity, called Return on Net Worth, shows a company’s profitability by calculating how much shareholders earn for their investment in the firm. 

For instance, ROE shows you how companies utilise shareholders’ money. It is determined by measuring a company’s net profit by its net worth. ROE varies depending on the sector the company operates. 

ROE measures the company’s operating efficiency. It shows how the company uses its assets and financial leverage to generate revenue for the business. 

Return on Equity Formula:

ROE = Profit After Tax (PAT) / Net Worth

Net Worth = Equity Capital + Reserves And Surplus

ROE can be broken up into three steps called Dupont Analysis. 

PAT / Net Worth = (PAT/Net Sales) * (Net Sales / Total Assets) * (Total Assets / Net Worth)

 
ROE = Net Profit Margin * Total Asset Turnover Ratio * Equity Multiplier.

How to calculate Return on Equity?

ROE = Profit After Tax (PAT) / Net Worth (Shareholders Equity)

You can determine profit after tax from a company’s income statement. It shows the company’s earnings before it pays out dividends to its shareholders. 

Example 1: 

Suppose Company XYZ Ltd’s current net income (Profit After Tax) is Rs 2,000 crore. It has a net worth (shareholder’s equity) of Rs 15,000 crore.

ROE = 2,000 / 15,000 = 13,333.

Let’s understand ROE better through Dupont Analysis:

ROE = Net Profit Margin * Total Asset Turnover Ratio * Equity Multiplier (Financial Leverage).

ROE can go up if a company’s net profit margin rises. Moreover, it can also go up if the total asset turnover ratio increases or because of higher financial leverage. For example, a company may use financial leverage, which is borrowing funds, to grow and expand the business. However, growth comes at a cost as the company incurs interest expenses on its borrowings. 

Let’s understand ROE with another example. Look at the figures below for Company ABC Ltd and Company XYZ Ltd. 

Particulars	Company ABC Ltd (Rs / Crore)	Company XYZ Ltd (Rs / Crore)
Revenue	12,000	11,800
Net Profit	2,400	2,620
Assets	5,200	5,000
Equity	2,600	5,000
Liability	2,600	0
ROE	92.30%	52.40%
Asset Turnover Ratio	2.3 X	2.4 X
Net Profit Margin	20%	22%
Asset / Equity	2 X	1 X

Inference:

• From the example, you will notice that Company ABC Ltd. and Company XYZ Ltd. are of similar size. 
• At a glance, you see that Company ABC Ltd has a higher ROE than Company XYZ Ltd., indicating better performance. 
• However, if you break ROE into three parts (Dupont Analysis), you get a different picture. 
• Company XYZ Ltd has a slightly higher Asset Turnover Ratio and Net Profit Margin than Company ABC Ltd. 
• Company XYZ Ltd. has a lower ROE than Company ABC Ltd. because of low financial leverage. (Company ABC borrows to finance the business, unlike Company XYZ). 
• However, Company ABC Ltd. faces pressure to service interest expenses, making it a riskier investment than Company XYZ Ltd. 

What is the significance of Return on Equity?

• ROE shows you the financial soundness of a firm. For example, companies with a higher return on equity than peers may generate higher returns for their shareholders. 
• You may compare a company’s ROE across different periods to track the performance of the company’s management. 
• You may look for companies with steady and rising ROE over the past five to seven years to identify multibagger stocks. 
• Companies with Return on Equity (ROE) of around 15%-20% over five or more years could be a good investment. 

What are the limitations of Return on Equity?

• ROE is used to compare the performance of companies in the same industry. You cannot gauge the performance of companies in different sectors. 
• ROE may be higher for new companies where capital requirements are higher in the initial days. 
• Company’s may manipulate ROE through accounting caveats like decreasing the depreciation rate or increasing the project life. 
• Companies may raise capital through debt (borrowings) which increases the ROE. However, the firm may default on interest obligations putting shareholders money at risk.

Return on Equity vs Return on Capital Employed:

Return on Capital Employed (ROCE) is determined by dividing operating profit post taxes by the capital employed. It is the sum of a company’s fixed assets and working capital. 

ROE and ROCE help you understand a company’s efficiency relative to the capital employed by the firm. However, ROCE is a superior measure to ROE as it focuses on the debt and equity of a company. Hence, investors may use ROCE to assess the performance of companies for whom the debt is an essential component. 

Conclusion:

1. ROE cannot be used to measure the performance of companies which don’t make profits. 
2. Companies with high ROE dominate their market segment and may generate wealth for shareholders over time