The return on equity indicator ROE (Return On Equity) is one of the most important financial indicators for investors. Unlike the return on assets (ROA) indicator, ROE characterizes the efficiency of using not all of the company's capital, but only that part of it that belongs to its shareholders. Expressed as a percentage and calculated as:
- ROE = Net Profit / Equity Value x 100
- ROE = Net Income / Shareholder’s Equity x 100
The amount of net profit is taken for the financial year, excluding dividends paid on ordinary shares (taken into account when calculating the ROCE ratio), but taking into account dividends paid on preferred shares (if any). Share capital is taken without taking into account preference shares.
ROE is the rate at which a company's shareholders' funds work. So, if ROE = 20%, this means that for every dollar invested by shareholders, the company generated $0.20 in net income.
Comparing return on equity with return on assets (ROA) provides insight into financial leverage - debt financing
For ordinary shares, the return on common equity (ROCE) indicator is used. Expressed as a percentage and calculated as:
- ROCE = Net income – Preferred dividends / Cost of equity – Preferred shares x 100
- ROCE = Net Income – Preferred Dividends / Shareholder’s Equity – Preferred Stocks x 100
ROE should be compared to the ROE of similar companies, as well as to alternative investment options available in the market. If the company's ROE is consistently below market rates of return, then it is more advisable to liquidate the business and invest money in market assets.
As ROE increases, the P/B multiplier should also increase. Low ROE and high P/B may indicate that the stock is overvalued. High ROE and low P/B mean that the market underestimates the company's potential.
It is also important to consider that the company can improve its ROE ratio, buying back its own shares from the market, thereby reducing their number in circulation and increasing the return on equity. As a result, this may give the investor an erroneous impression of the issuer's business performance.
As for the standard value of ROE, in the long term the return on capital should not be lower than low-risk investments in financial instruments. Because if the return on capital of a business is lower than the rates on deposits in large banks or on bonds, then the business ceases to be profitable for its owners.
- For example, if it is expected that in the next 3 years deposit rates will be in the range of 8-10%, then any business that will bring 10-12% on capital is unpromising, since it must be taken into account that the risks of doing business are much higher, than investments in government bonds or deposits.
Thus, the prospects of a business are assessed taking into account rates on low-risk investments (bonds or deposits in large banks) and risk premiums (corporate, market, economic, political, etc.).
Equity capital characterizes the return on shareholders' investments in terms of the profit received by the company. This coefficient can be abbreviated ROE (return of investment) and have a different name - to joint stock. The calculation is made using the formula:
Net income includes dividends paid on preferred stock but excludes those paid on common stock. The capital value does not take into account preferred shares.
How is return on equity useful?
It makes it possible to judge how effectively it is used. It is important to consider: the ratio demonstrates the efficiency of only that part of the capital that belongs to the owners of the company. The ROE indicator is considered not the most reliable indicator of the financial condition of an organization - it is generally believed that it overestimates the value of the company.
There are five main ways to interpret meaning:
1. Depreciation. A high ROE indicates uneven depreciation.
2. Growth rate. Companies that are growing rapidly have low ROE.
3. Project duration. Long-term projects are characterized by a high coefficient value.
4. Time gap. The longer the time period between investment expenses and the return on them, the higher the ROE.
Definition
Return on equity(return on equity, ROE) - an indicator of net profit in comparison with the organization’s own capital. This is the most important financial indicator of return for any investor or business owner, showing how effectively the capital invested in the business was used. Unlike a similar indicator of “assets,” this indicator characterizes the efficiency of using not all of the capital (or assets) of the organization, but only that part of it that belongs to the owners of the enterprise.
Calculation (formula)
Return on equity is calculated by dividing net profit (usually for the year) by the organization's equity:
Return on Equity = Net Profit / Shareholders' Equity
To obtain the result as a percentage, the specified ratio is often multiplied by 100.
A more accurate calculation involves using the arithmetic average of equity for the period for which net profit is taken (usually for the year) - equity at the end of the period is added to equity at the beginning of the period and divided by 2.
The organization's net profit is taken according to the "Profit and Loss Statement", equity capital - according to the liabilities of the Balance Sheet.
Return on equity = Net profit*(365/Number of days in the period)/((Equity at the beginning of the period + Equity at the end of the period)/2)
A special approach to calculating return on equity is to use the Dupont formula. The Dupont formula breaks the indicator into three components, or factors, that allow a deeper understanding of the result obtained:
Return on Equity (Dupont Formula) = (Net Profit / Revenue) * (Revenue / Assets) * (Assets / Equity) = Net Profit Return * Asset Turnover * Financial Leverage.
Normal value
According to average statistical data, return on equity is approximately 10-12% (in the USA and UK). For inflationary economies, such as the Russian one, the figure should be higher. The main comparative criterion when analyzing return on equity is the percentage of alternative return that the owner could receive by investing his money in another business. For example, if a bank deposit can bring 10% per annum, but a business brings only 5%, then the question may arise about the advisability of further running such a business.
The higher the return on equity, the better. However, as can be seen from the Dupont formula, a high value of the indicator can result from too high financial leverage, i.e. a large share of borrowed capital and a small share of equity capital, which negatively affects the financial stability of the organization. This reflects the main law of business - more profit, more risk.
Calculating return on equity makes sense only if the organization has equity capital (i.e. positive). Otherwise, the calculation gives a negative value that is of little use for analysis.
Let's look at the types of profitability and what affects it.
- operational efficiency (return on sales based on net profit);
- efficiency of use of all assets (asset turnover);
- ratio of equity and debt capital (financial leverage).
Return on assets
Return on assets (ROA) is a financial ratio that characterizes the return on use of all assets of an organization.
The ratio shows the organization's ability to create profit without taking into account the structure of its capital (financial leverage), as well as the quality of asset management. Unlike the return on equity (ROE) indicator, this ratio takes into account all the assets of the organization, and not just equity. Therefore, it is less interesting for investors.
Return on assets is highly dependent on the industry in which the organization operates. For capital-intensive industries (electric power, railway transport) this figure will be lower. For service sector enterprises that do not require large capital investments and investments in working capital, the return on assets will be higher.
Return on invested capital
Return on invested capital (return on capital employed, ROCE) is an indicator of the return on equity capital and long-term funds invested in the commercial activities of an organization.
It is usually needed to compare the performance of different types of businesses and to assess whether the company generates enough profits to justify the cost of borrowing money at a certain interest rate. If the interest on the loan is higher than the return on invested capital, then the organization will not be able to use the loan effectively enough to pay off the interest. Therefore, it makes sense to take only those loans whose interest rate is lower than the return on invested capital.
EBITDA margin
EBITDA margin (Earnings Before Interest, Taxes, Depreciation and Amortization) - earnings before interest, taxes and depreciation. The ratio shows the financial result of the organization, excluding the influence of capital structure (interest paid on loans), taxes and accrued depreciation. EBITDA allows you to evaluate cash flow without such non-cash expense item as depreciation. The indicator is useful when comparing companies in the same industry but with different capital structures. Investors look to EBITDA as an indicator of the expected return on their investment.
EBIT return on sales
Return on sales by EBIT (Earnings before interests and taxes) is the amount of profit from sales before interest and taxes in each ruble of revenue.
This ratio is intermediate between gross and net profit. Subtracting interest and taxes allows you to compare different businesses without taking into account leverage and tax rates.
A positive EBIT value is considered normal. However, you need to keep in mind that after subtracting interest and taxes, you may end up with a loss.
Return on sales by gross profit
Return on sales by gross profit (Gross Margin, Sales margin, Operating Margin) is a profitability ratio that shows the share of profit in each ruble earned. It is usually calculated as the ratio of net profit (profit after tax) for a certain period to the sales volume expressed in cash for the same period.
Return on sales based on net profit
Return on sales based on net profit (English: Profit Margin, Net Profit Margin) - profit from sales per ruble invested in the production and sale of products (works, services).
Profitability of production assets
Return on production assets (capital productivity; English output/capital ratio) - shows how many products the enterprise produces for each invested unit of fixed assets value. The higher the capital productivity of fixed assets, the lower the costs per 1 ruble of production. The capital productivity indicator depends on the industry, structure and characteristics of production.
Return on equity
Return on equity (ROE) - characterizes the profitability of a business for its owners, calculated after deducting interest on the loan.
This is the most important financial indicator of return for the investor and business owner, showing how effectively the funds invested in the business were used. Unlike return on assets (ROA), this ratio characterizes the efficiency of using not the entire capital (or assets) of the organization, but only that part of it that belongs to the owners of the enterprise.
Three factors influence return on equity:
The return on equity ratio is compared to the percentage of alternative return that the owner could receive by investing his money in another business. For example, if a business brings in only 4% of profit per year, and a bank deposit can bring in 12% per annum, then the question arises about the advisability of further running such a business. The higher the return on equity, the better. However, a high value of the indicator may result from too high financial leverage, i.e. a large share of borrowed funds and a small share of own funds, which has a bad effect on the financial stability of the organization.
Calculating the return on equity ratio makes sense only if the organization has equity capital (i.e., positive net assets). Otherwise, the calculation gives a negative value of the indicator, which is poorly suitable for analysis.
Return on equity of the enterprise. Indicators, coefficient and formula of return on equity
Own capital (eng. ROE, i.e. return on equity) is an indicator of net profit in comparison with the organization's own capital. This is the most important financial indicator of return for any investor or business owner, showing how effectively the capital invested in the business was used. Unlike the similar indicator “return on assets,” this indicator characterizes the efficiency of using not all of the capital (or assets) of the organization, but only that part of it that belongs to the owners of the enterprise.
Return on equity is one of the most important indicators of business efficiency. Any investor, before investing his finances in an enterprise, analyzes this parameter. It shows how well the assets belonging to owners and investors are used. The return on equity ratio reflects the ratio of net profit to the company's equity. It is clear that such a calculation makes sense when the organization has positive assets that are not burdened with borrowing restrictions.
Return on equity indicators
According to average statistics, return on equity in the US and UK is approximately 10-12%. For inflationary economies, such as the Russian one, the figure should be higher. The main comparative criterion when analyzing return on equity is the percentage of alternative return that the owner could receive by investing his money in another business. For example, if it can bring 10% per annum, but the business brings only 5%, then the question may arise about the advisability of further running such a business.
According to the international rating agency S&P, the return on capital ratio of Russian enterprises was 12% in 2010, the forecast for 2011 was 15%, for 2012 - 17%. Domestic economists believe that 20% is a normal value for return on equity.
The higher the return on equity, the better. However, as can be seen from the Dupont formula, a high value of the indicator can result from too high financial leverage, i.e. a large share of borrowed capital and a small share of equity capital, which negatively affects the financial stability of the organization. This reflects the main law of business - more profit, more risk.
Calculating return on equity makes sense only if the organization has equity capital (i.e., positive net assets). Otherwise, the calculation gives a negative value that is of little use for analysis.
The following indicators influence return on equity:
Efficiency of operating activity (net profit from sales);
Return of all assets of the organization;
The ratio of own and borrowed funds.
How to evaluate the return of a business by looking at the profitability ratio?
To do this, it is worth comparing it with indicators of alternative returns. How much will a businessman get if he invests his money in another business? For example, he will take the funds to a bank deposit, which will bring 10% per annum. And the profitability ratio of the existing enterprise is only 5%. It is clear that developing such a company is inappropriate.
Compare the indicator with the standards historically established in the region. Thus, the average profitability of companies in England and the USA is 10-12%. In countries with stable economies, a ratio of 12-15% is desirable. For Russia - 20%. In each specific state, the values of the indicator are influenced by many factors (inflation, industrial development, macroeconomic risks, etc.).
High profitability does not always mean high financial results. The higher the ratio, the better. But only when the majority of investments are the enterprise’s own funds. If debt prevails, the solvency of the organization is at risk.
Thus, a huge debt load is dangerous for the financial stability of the company. It is useful to calculate return on equity if the company has this same capital. The predominance of borrowed funds in the calculation gives a negative indicator, practically unsuitable for analyzing the return of a business.
Although one cannot be categorical about the profitability ratio. Its use in analysis has some limitations. The real income of the owner or investor does not depend on assets, but on operating efficiency (sales). It is difficult to assess the productivity of a company based on a single indicator of the return on its own capital investments.
Most companies have significant amounts of debt. The same banks exist only on borrowed funds (attracted deposits). And their net assets serve only as a guarantor of financial stability.
Be that as it may, the profitability ratio illustrates the income a company earns for investors and owners.
Return on Equity Formula
The company's return on equity shows the amount of profit that the company will receive per unit of equity value. For a potential investor, the value of this indicator is decisive:
The profitability ratio gives an idea of how well the invested capital was used.
The owners invest their funds, forming the authorized capital of the enterprise. In return, they are entitled to a percentage of the profits.
Return on equity reflects the amount of profit that an investor will receive from each ruble advanced to the company.
The calculation of the formula for return on equity on the balance sheet is the ratio of net profit for the year to the enterprise's equity for the same period. Data is taken from the “Profit and Loss Statement” and “Balance Sheet”. If you need to find the coefficient as a percentage, then the result is multiplied by 100.
Net return on equity formula:
RSK = PE / SK (average) * 100, where
RSC - return on equity,
PE - net profit for the billing period,
SK (average) - the average size of investments for the same billing period.
Example of formula calculation. Company A has its own funds in the amount of 100 million rubles. Net profit for the reporting year amounted to 400 million. RSC = 100 million/400 million * 100 = 25%.
An investor can compare several companies to decide where it is more profitable to invest money.
Example. Firms “A” and “B” have the same equity capital, 100 million rubles. The net profit of enterprise “A” is 400 million, and that of enterprise “B” is 650 million. Let's substitute the data into the formula. We find that the profitability ratio of company “A” is 25%, “B” is 15%. The profitability of the first organization was higher at the expense of its own funds, and not at the expense of revenue (net profit). After all, both enterprises entered into business with the same amount of capital investment. But company B did a better job.
Formula for financial return on equity
To obtain more accurate data, it makes sense to divide the analyzed period into two: calculate income at the beginning and at the end of a certain period of time.
The calculation is:
RSK = PE * 365 (days in the year of interest) / ((SKng + SKkg)/2), where
SKng - equity capital at the beginning of the year;
SKkg - the amount of own funds at the end of the reporting year.
If the indicator must be expressed as a percentage, then the result is accordingly multiplied by 100.
What numbers are taken from accounting forms?
To calculate net profit (from form No. 2, “Profit and Loss Statement”; line numbers and their names are indicated):
2110 “Revenue”;
2320 “Interest receivable”;
2310 “Income from participation in other organizations”;
2340 “Other income”.
To calculate the amount of equity capital (from form N1, “Balance Sheet”):
1300 “Total for the section “Capital and reserves”” (data at the beginning of the period plus data at the end of the period);
1530 “Income for future periods” (data at the beginning plus data at the end of the reporting period).
Formula for calculating the standard level of profitability
How to understand that it makes sense to invest in a business? Return on equity shows the standard value. One way is to compare the profitability with other options for advancing money (investing in shares of other companies, buying bonds, etc.). The standard level of return is considered to be interest on deposits in banks. This is a certain minimum, a certain limit for determining the return of a business.
Formula for calculating the minimum profitability ratio:
RSK (n) = Std * (1 - Stnp), where
RSC (n) - standard level of return on equity (relative value);
Std - deposit rate (average for the reporting year);
Stnp - income tax rate (for the reporting period).
If, as a result of calculations, the return on invested own financial resources turns out to be less than RSC (n) or receives a negative value, then it is not profitable for investors to invest in this company. The final decision is made after analyzing profitability over the past few years.
DuPont formula for calculating return on equity
To calculate the return on equity ratio, the DuPont formula is often used. It breaks the coefficient into three parts, the analysis of which allows you to better understand what influences the final coefficient to a greater extent. In other words, this is a three-factor analysis of the ROE ratio. Dupont's formula is as follows:
Return on equity ratio (Dupont formula) = (Net profit/Revenue) * (Revenue/Assets)* (Assets/Equity)
The Dupont formula was first used in financial analysis in the 20s of the last century. It was developed by the American chemical corporation DuPont. Return on equity (ROE) according to the DuPont formula is divided into 3 components:
Operational efficiency (return on sales),
Efficiency of asset use (asset turnover),
Leverage (financial leverage).
ROE (according to the DuPont formula) = Return on sales * Asset turnover * Leverage
In fact, if you reduce everything, you will get the formula described above, but such a three-factor separation of components allows you to better determine the relationships between them.
Return on equity ratio
The return on equity ratio is one of the most important ratios used by investors and business owners, which shows how effectively the money invested in the enterprise was used.
The difference between return on equity (ROE) and return on assets (ROA) is that ROE does not show the performance of all assets (like ROA), but only those that belong to the owners of the enterprise.
This indicator is used by investors and owners of an enterprise to evaluate their own investments in it. The higher the ratio, the more profitable the investment. If the return on equity is less than zero, then there is reason to think about the feasibility and effectiveness of investment in the enterprise in the future. As a rule, the value of the coefficient is compared with alternative investments in shares of other enterprises, bonds and, in extreme cases, in a bank.
It is important to note that too high a value of the indicator can negatively affect the financial stability of the enterprise. Don't forget the main law of investment and business: more profitability - more risk.
Maxim Shilin
Especially for the Information Agency "Financial Lawyer"
