Return on Equity (ROE)

Return on Equity (ROE) is a key financial metric that measures a company’s profitability relative to its shareholders’ equity. It indicates how effectively management is using equity capital to generate profit.

This important ratio is often used by investors to compare companies within the same industry and to assess year-over-year performance for a single firm. A consistently high or rising ROE suggests efficient use of equity capital, making the company an attractive investment.

However, ROE also has its limitations. For example, high levels of debt can inflate ROE because the denominator (shareholders’ equity) decreases as debt rises. In capital-intensive industries like manufacturing or utilities, significant assets funded through debt may lead to misleadingly high ROE figures. In such cases, Return on Capital Employed (ROCE) may provide a more complete picture by factoring in debt.

Be cautious when comparing companies with vastly different debt levels, even within the same industry. A firm with moderate ROE and low debt may be a safer investment compared to one with high ROE driven largely by heavy debt, which increases financial risk and can be problematic if interest rates rise.

Another limitation is that ROE is based on past performance data, which may include one-time gains or losses that distort the true profitability of ongoing operations. Despite these caveats, ROE remains one of the most powerful tools for evaluating management effectiveness and investment quality.

ROE Formula: Understanding Return on Equity

Return on Equity (ROE) is calculated by dividing Net Income by Shareholders’ Equity. The net income should be taken from the trailing twelve months (TTM) and can be found on the company’s income statement. Shareholders’ equity is listed on the balance sheet and represents total assets minus total liabilities.

This metric reveals the percentage of profit generated for each dollar of equity invested. For example, an ROE of 20% means the company earned $0.20 for every $1.00 of equity over the past year.

In the United States, net income is typically measured after tax, aligning ROE with an after-tax performance metric.

Formula: ROE = Net Income / Shareholders' Equity

You can estimate shareholders’ equity by averaging the equity figures from the past four quarters. This approach helps smooth out any seasonal variations or one-time events that may impact the data.

What is a good return on equity?

Whether an ROE number should be considered good or bad depends on the industry.

Many industries inherently have either a low or high ROE. For example, utility companies tend to have low ROEs, while profitable tech companies tend to have high ROEs.

Because of this, ROE is mostly useful when comparing peers within the same industry.

But generally speaking, many consider an ROE of around 15–20% to be acceptable. To put that in perspective, the S&P500 index had a return on equity of 16.2% for Q4 of 2022 (1).

However, looking at a single ROE number can be unreliable.

This is because ROE depends on net income, which is a volatile number that often changes based on one-time accounting items, thus causing ROE to swing wildly from one year to the next.

To get a good idea of whether a company is doing well, it helps to look at how ROE has evolved over time. A stable or rising number is optimal.

Conversely, if ROE is declining over time, it could indicate that the company is making poor decisions on where to invest its money.

Summary

What's considered a good ROE number depends on a company's industry. Additionally, it's best to look at ROE trends over time, which you want to be either stable or rising, instead of relying solely on a single number.

Real-World Examples: ROE Comparisons

Here are some real-world examples of companies with impressive ROE figures, demonstrating their effective use of equity capital to generate profits.

• Apple (AAPL): In 2022, with a net income of $99.8 billion and shareholders’ equity of $165.9 billion, Apple achieved an ROE of $99.8B / $165.9B = 60.13%.
• Microsoft (MSFT): In 2022, Microsoft recorded a net income of $72.7 billion and shareholders’ equity of $192.6 billion, resulting in an ROE of $72.7B / $192.6B = 37.76%.
• Alphabet (GOOGL): In 2021, Alphabet posted a net income of $76.0 billion and shareholders’ equity of $251.0 billion, yielding an ROE of $76.0B / $251.0B = 30.28%.

These examples underscore the value of ROE as a quick yet powerful indicator of a company’s profitability and management efficiency.

Whether you’re an investor, financial analyst, or business owner, understanding and utilizing ROE can greatly enhance your ability to evaluate investment opportunities and operational performance.