Return on equity (ROE) is a measure that helps financial advisors understand how well a company uses its shareholders’ investments to generate profit. For financial advisors, knowing how to interpret and explain ROE can be beneficial, especially when conducting fundamental analysis.
In this article, Wealth Professional Canada will walk you through what ROE is and how to use it to guide your clients.
ROE is a financial ratio that shows how much profit a company makes from every dollar of shareholders’ equity. In other words, ROE helps you see how efficiently a business is using the money invested by its shareholders to generate earnings.
This ratio is also a quick way to compare the profitability of different companies or track a company’s performance over time.
Watch this video to better understand ROE:
ROE is also a critical component when conducting fundamental analysis because it shows how effectively a company turns shareholders’ equity into profit.
To calculate ROE, you need two numbers: net income and average shareholders’ equity. Net income is the company’s profit after taxes while shareholders’ equity is the value left for shareholders after subtracting liabilities from assets. Here’s the formula for calculating the ROE:
Net income is usually found at the bottom of the income statement. Shareholders’ equity is on the balance sheet. To get the average, add the equity at the start and end of the period, then divide by two.
To figure out what a company’s ROE is, use the formula above. Better yet, use the calculator at the beginning of this article!
This metric is essential because it tells financial advisors how well a company is using its investors’ money. A higher ROE can suggest that the firm is generating more profit from each dollar of equity. This can signal good management and efficient use of resources. For your clients, companies with strong ROE can be attractive investments, as they might offer better returns.
However, ROE should not be used alone. It is best to compare ROE with similar companies in the same industry and to look at trends over time. This can help you spot whether a company is improving or falling behind its peers.
A good ROE depends on the industry, but for most companies, an ROE between 15 and 20 percent is considered strong. This range shows that a company is using its shareholders’ money efficiently to generate profits. Look for companies with ROE in this range or higher, especially if the company has maintained or improved its ROE over time.
It’s also important to compare ROE with other companies in the same sector. Some industries naturally have higher or lower ROE due to their business models. For example, technology companies often have higher ROE than utilities.
A low ROE, usually below five percent, can be a warning sign. It might mean that the company is not using its equity well or is struggling to generate profits. To be safe, advise your clients to be cautious about investing in a company with low ROE.
Sometimes, a negative ROE can occur if a business has negative net income or negative equity. This is a red flag and needs closer evaluation. If both net income and equity are negative, the ROE might appear positive due to the math, but this does not mean the company is healthy. To be certain, always check the underlying numbers beforehand.
ROE is a helpful metric, but it should not be used in isolation. Financial advisors should use ROE to:
A rising ROE over several years can show that management is making good decisions and creating value for shareholders. On the other hand, a falling ROE might be a sign of trouble or poor capital allocation.
Watch this video for more:
Let’s look at a sample scenario. Suppose that a large Canadian tech company reports a net income of $2 billion. Its shareholders’ equity at the start of the year was $8 billion, and at the end, it was $10 billion. The average equity is $9 billion.
Using the formula for getting the ROE, you’ll get 22.2 percent. This result can suggest that the company is using its shareholders’ money efficiently. If the company’s ROE has been rising for several years, this is a positive sign for your clients.
ROE is useful, but it has its limits. It does not show how much debt a company has. A company can boost its ROE by taking on more debt, which then increases risk. For example, if two companies have the same ROE but one has much more debt, the one with less debt is usually safer for your clients.
ROE can also be affected by one-time events, such as asset write-downs or share buybacks. These can make ROE look better or worse than it really is.
Aside from these limits, financial advisors should also be aware of other concerns:
ignoring debt: high ROE can sometimes mean a company is using a lot of debt, so always check the company’s debt levels
not using averages: using just the year-end equity can give a misleading ROE; use the average equity for the period
comparing different industries: remember to only compare ROE between companies in the same industry.
relying on ROE alone: use ROE with other metrics like the price-to-book (P/B) ratio and other financial data for a complete analysis
ROE can sometimes give a false impression. For example, if a company buys back its own shares, the equity goes down. This can make ROE go up even if profits have not improved. One-time gains or losses can also distort ROE for a single year.
If a company has negative equity, the ROE calculation can be confusing. A company with negative equity and negative net income can show a positive ROE, but this is not a good sign. To avoid this pitfall, consider all elements before giving any advice to your clients.
For instance, check the firm’s market capitalization and other measures along with ROE.
Financial advisors can use ROE to:
When presenting ROE to your clients, make sure to explain how it’s calculated and why it’s vital when building their portfolios. You can also use simple examples (such as our sample scenarios above) and compare companies in the same sector for clarity.
ROE is a valuable ratio, but you must use it together with other financial ratios to evaluate a company’s performance. Here are some metrics to consider:
ROA measures how well a company uses all its assets to generate profit. It is calculated by dividing net income by total assets. A higher ROA can suggest that the company is making good use of its resources to earn money for your clients.
This measures the profit a company makes after subtracting the cost of goods sold from revenue. It is calculated by dividing gross profit by total revenue. The gross profit margin can help you see how well a company controls its production or purchase costs.
This ratio shows how much profit a company keeps from each dollar of sales after all expenses are paid. It is calculated by dividing net income by total revenue. A higher net profit margin can mean that the company is more efficient at turning sales into actual profit.
The D/E ratio compares a company’s total debt to its shareholders’ equity. It is calculated by dividing total liabilities by shareholders’ equity. A lower ratio can mean that the company relies less on borrowed money. This can be a safer option for your clients.
On the other hand, a higher ratio might suggest more debt, which can increase risk but also boost returns if managed well.
Using these ratios together with ROE will give you a more complete picture of a company’s financial health. It can also help you make better recommendations for your clients.
With ROE, you can quickly assess how well a company is using its shareholders’ money to generate profits. A strong ROE often points to good management and efficient capital use. On the contrary, a low or negative ROE can signal problems that need closer attention.
Still, what counts as a “good” or “bad” ROE depends on the industry and should be compared with similar companies. As mentioned above, it’s vital to use ROE alongside other financial ratios to get a fuller view of a company’s financial wellbeing.
Remember that ROE can be influenced by factors like debt levels and share buybacks. Even one-time events can have an impact. That’s why you must always look at the bigger picture. By using ROE as part of your analysis, you can help your clients choose wisely with their investments and build better asset mixes.
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