ROE measures a firm's annual return (net income) divided by the amount of its shareholders' total equity expressed in percentage (e.g., 12.5%). Additionally, ROE can be calculated by dividing the company's yield growth by the retained earnings rate (1 the dividend rate of payout).
It is considered a dual ratio, which is why it is a combination of the income statement and balance sheet, in which net income or profits are measured against the equity of shareholders. It is the sum of the returns on capital equity and illustrates the capacity of the firm to convert equity investments into earnings. Put another way; it measures the profit earned for every dollar of shareholder's equity.
Why ROE Matters
A return on equity (ROE) measure reveals how much a business generates profits from the money investors have invested into the company. ROE calculates ROE by dividing net earnings by the equity of the shareholders. ROE is an extremely useful metric for evaluating and comparing comparable companies, indicating the earnings performance.
The returns on equity averages vary dramatically between different industries, so it's not recommended to utilize ROE to make cross-industry comparisons of companies. A higher equity return suggests that the company uses the contribution from equity investors to generate additional profits and reasonably return earnings to the investors. However, companies can have lower equity bases. In this case, the relatively lesser percentage of their net earnings could result in a higher ROE proportion from a smaller amount of equity.
How to Use
Certain industries are more likely to have higher ROEs than others, which is why ROE is the most valuable when comparing businesses within the same sector. Certain industries with cyclical characteristics tend to produce greater ROEs than defensive ones because of the various risk factors attributed to their respective industries. A more risky company is likely to have a higher capital cost and a greater equity expense.
Additionally, it's beneficial to compare a company's ROE against its costs of equity. A business with an equity return higher than its equity cost has gained value. The stock of a company with 20 percent ROE is typically worth twice as much as a company with 10 percent ROE (all other factors being the same).
Bank Return on Equity
While most companies are focused on calculating earning per share (EPS) growth, banks focus on ROE. Investors have discovered that ROE is a superior indicator of the value of their shares and the expansion of banks. This is because the base of capital for banks is different from traditional businesses, as the federal government insures deposits in banks. In addition, banks can offer interest on deposits that are a form of capital far below the rate that other companies have to pay for capital.
However, minimum capital requirements like Basel III increased the number of capital banks have to maintain in their reserves. This has led to ROEs falling. This has led to banks' average ROEs being lower since the passing of the reform in 2009. From the 1990s until the mid-2000s period, banks were able to achieve an ROE of mid-teens. Following Basel III, U.S. banks' average ROE varied between 5-12% from 2010 until 2020.
It was reported that the St. Louis Federal Reserve stopped reporting the banking industry's ROE following the 3rd quarter of 2020; at that point, it was reported that the ROE was 5.31 percent. The "Supervision and Regulation Report" released in November 2021 reported that the Federal Reserve reported an average bank ROE of 14% in the 3rd Quarter of 2021. This was a significant increase in bank profits greater than levels pre-COVID.
Drawbacks
The ratio of return on equity is also affected by share buybacks. When the management buys its shares on the market and reduces the number of shares in circulation, ROE grows as the denominator decreases.
Another issue is that certain ROE ratios could remove intangible assets out of the equity of shareholders. Intangible assets are items that are not monetary, like trademarks, goodwill, or copyrights, as well as patents. This could make calculations inaccurate and hard to compare with other companies that have decided to incorporate intangible assets.
The ratio also includes certain variations in its composition, and there could be differences between analysts. For instance, shareholders' equity could be the beginning or ending number, or the median of the two Net Income could replace EBITDA and EBIT. It could be adjusted or not for non-recurring elements.
