What is ROE? How to calculate and mean ROE in finance

What is ROE?

ROE is earnings yield On Equity. This coefficient has an important role to measure the source of capital gain that investors have spent. In short, ROE is an index that shows the effective use of capital investment in a business.

ROE is earnings yield on equity

Stock investors are often interested in ROE because it shows whether their investment is being used properly by the business. This can also be seen as an index to show and assess the financial health of enterprises on the stock market.

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Meaning of ROE

ROE has many meanings in whether investors want to invest in a company or not. Specifically:

• ROE allows shareholders to know if they have received a lot of benefit from their source of source of capital contribution to the company in the form of stock ownership.
• The company will likely have to generate a higher ROE than the earnings yield on low-risk investments to satisfy investors and shareholders.
• ROE will be compared and contrasted the corresponding indicators in the past and with the average ROE index average in the business to assist viewers in fully knowing the profitability and efficiency of the organization's investment activities.
• Earnings are proportional to ROE. The higher the earnings, the higher the ROE, and the higher the earnings per share.
• Investors can determine a company's competitive advantage by comparing its ROE with the industry average. This index will let investors know how the company's management has used equity to grow the company.
• If the ROE develops sustainably over time, it proves that the company has promoted effective use of source of source of capital, created value for shareholders, and increased productivity and profit. On the contrary, when a poor ROE shows that the company's management has not managed its source of source of capital well, business decisions are not effective, and its profitability is not good.

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ROE is calculated using the formula:

ROE = Net Income / Average Equity of Shareholders

In there:

• Net income is determined before dividends are paid to common stockholders and after preferred shares are paid and interest on corporate loans. This metric is extracted directly from the company's income statement. ROE can be calculated easily if net income and equity are positive number.
• The average equity of shareholders is the result of the calculation of equity addition at the beginning of the company's accounting period. The beginning and the end of the period must coincide with the period in which the business earns net income. This data can be obtained from the balance sheet of the business.

This index can also be calculated by the formula:

ROE = Sustainable Growth Rate (SGR) / Retention Rate

In there:

• The sustainable growth rate (SGR) is the maximum growth rate a business can sustain without having to increase it by adding more equity or increasing debt.
• Retention ratio = 1 - dividend payout ratio to shareholders.

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ROE for stock investment

How much ROE is good?

To answer the question of how much ROE is good, you need to determine which industry the business is operating in. Each industry and business sector has a different average.

How much ROE is good?

ROE of import-export enterprises cannot be compared with those of enterprises operating in the social sector.

• General rule: Investment should be focused on businesses with ROE greater than or equal to the industry average of the company.
• Some investors consider ROE to be close to the long-term average of the S&P 500. Of which, 14% is an acceptable ratio, if lower than 10% is a poor ratio.

Example: Company ABC has had a stable ROE for the past 6 years of 18%. Meanwhile, the industry average ROE is 15% → It can be concluded that ABC company is using source of capital efficiently, generating profits that are always above average.

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Earnings yield On Equity is too high, what to notice

A medium or high ROE will often take precedence over a low ROE. However, too high ROE, especially above the peer group average, is not necessarily a good thing.

Too high ROE is not necessarily a good sign

A high ROE is considered a good sign when net income from production and business activities is much larger than the amount of equity. This is proof that the company is thriving. But if equity is much less than net income, the company is exposed to quite a lot of risk.

• Too small of equity could be because the company has been losing money for a long time. These losses will all be reported in the equity section as “retained loss” in the balance sheet. This will reduce the equity of the business if maintained in the long run.
• If the company is growing again and recording high profits, the result of the ROE will also suddenly increase because the equity is too small. At this point, a high ROE can mislead investors that the company is growing very strongly.

At the same time, equity will also decrease when the company has too much debt. At this time, the calculated result of the ROE is also abnormally high.

Limitations of ROE

ROE has many meanings for investors but also contains many disadvantages. Too high ROE is not necessarily a good sign. So, when learning what is ROE, you should be aware of its limitations. ROE can also experience deviations due to the influence of many factors such as large debt, stock repurchases, long-term losses, etc.

ROE also has its limitations

Another disadvantage is that ROE can remove intangible assets from equity such as patents, copyrights, trademarks. Therefore, ROE is sometimes unavoidable, making it difficult to compare with businesses that also calculate intangible assets.

Each investor may calculate a different ROE by using different components in the formula such as: equity at the beginning, end of the period or the average of two periods,... This leads to inconsistency in the data of each investor, leading to different decisions.

In the above article,  Viindoo introduced you to the most detailed information about ROE. Hopefully, through this article, investors will better understand this index and make effective investment decisions, bringing high profits.

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