How Return on Equity Can Help Uncover Profitable Stocks

“Two firms can have the same ROE and get there in completely different ways,” says Dr. Robert R. Johnson, professor of finance at Creighton University’s Heider College of Business. Emily Guy Birken is a former educator, lifelong money nerd, and a Plutus Award-winning freelance writer who specializes in the scientific research behind irrational money behaviors. Her background in education allows her to make complex financial topics relatable and easily understood by the layperson. She is the author of four books, including End Financial Stress Now and The Five Years Before You Retire. That’s why to gain a 360-degree view of a company’s efficiency, ROE must be viewed in conjunction with other factors, like ROA and ROI.

Similarly, if a company has several years of losses, which would reduce shareholder equity, a suddenly profitable year could give it a high ROE, simply because its asset-based denominator has shrunk so much. The underlying financial health of the company, however, would not have improved, meaning the company might not have suddenly become a good investment. A negative ROE due to the company having a net loss or negative shareholders’ equity cannot be used to analyze the company, nor can it be used to compare against companies with a positive ROE.

What Is the Difference Between Return on Assets (ROA) and Return on Equity (ROE)?

A high ROE can be misleading if it’s driven by excessive leverage or short-term financial engineering. It’s essential to consider other factors alongside ROE for a holistic evaluation. The ROE of the entire stock market as measured by the S&P 500 was 16.38% in the third quarter of 2023, as reported by CSI Market. The first, critical component of deciding how to invest involves comparing certain industrial sectors to the overall market. She holds a Bachelor of Science in Finance degree from Bridgewater State University and helps develop content strategies.

The return on equity (ROE) metric provides useful insights into how efficiently existing and new equity invested into the company is being utilized. However, if Joe’s instead took on $2 billion in debt to buy just $1 billion of candy canes, it would actually post a higher ROE. That’s because the denominator of the equation would be reduced by the additional $1 billion in debt, yielding a higher overall result. For heavily indebted companies, this can yield artificially high ROEs (unless, of course, the company’s liabilities outweigh its assets). A higher percentage indicates a company is more effective at generating profit from its existing assets. Likewise, a company that sees increases in its ROE over time is likely getting more efficient.

This can be a particular concern for fast-expanding growth companies, like many startups. While helpful, ROE should not be the only metric used to gauge a company’s financial health and prospects. When taken alone, there are a number of ways that the ROE calculation can be misleading. What makes for a good ROE depends on the specific industry of the companies involved.

Firm A has $500 in debt and therefore $500 in shareholders’ equity ($1,000 – $500), while Firm B has $200 in debt and $800 in shareholders’ equity ($1,000 – $200). Firm A shows a ROE of 24% ($120/$500) while Firm B, with less debt, shows an ROE of 15% ($120/$800). As ROE equals net income divided by the equity figure, Firm A, the higher-debt firm, shows the highest return on equity. The issuance of $5m in preferred dividends by Company A return on equity meaning decreases the net income attributable to common shareholders.

Example of how to use ROE

Taken together, ROE and ROA can help you determine how well a company is making use of its debt. For instance, while ROE will almost always be higher than ROA when a company has taken on debt, if the difference is huge, this could suggest the company is not making good use of its borrowed dollars. ROE often can’t be used to compare different companies in differing industries. ROE varies across sectors, especially as companies have different operating margins and financing structures. In addition, larger companies with greater efficiency may not be comparable to younger firms.

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2. If average equity cannot be calculated from the available data (e.g., beginning equity is not known), the equity at the end of the period may be used as the denominator.
3. Generally, a higher return on equity means the company is more efficient at generating profits.
4. A company’s management team can also use ROE to assess financial performance over time and find ways to improve.
5. That yields a better picture of the company’s financial health than the similar metric return on assets (ROA), which would reflect the value of the unsold candy canes but not the accompanying debt.

How Do You Calculate ROE Using DuPont Analysis?

Put simply, a company’s financial performance can tell you how healthy it is and whether it is financially sound. There are several key financial metrics that can help you determine whether a business is performing well or isn’t living up to industry standards. One of the figures that many analysts and investors use is the return on equity (ROE). In this article, we look at what ROE is, how to calculate it, and how it’s used when analyzing companies. Because shareholders’ equity is equal to a company’s assets minus its debt, ROE is a way of showing a company’s return on net assets.

Therefore, the fact that the company requires fewer funds to produce more output can lead to more favorable terms, especially in early-stage companies and start-ups. You can use it to make comparisons between companies within the same industry, as well as to assess trends over time. It’s a good idea to look at the larger context when analyzing ROE, not just relying on one calculation in isolation. In this case, even if the ROE goes up, the stock may have become a riskier investment by taking on debt. If unusual or large items cause the net income (numerator) or equity (denominator) to go up or down, then the calculated ROE may not be reliable. Most importantly, the ROE number can change drastically when the inputs to the equation change.

Investors

ROE can also be calculated at different periods to compare its change in value over time. By comparing the change in ROE’s growth rate from year to year or quarter to quarter, for example, investors can track changes in management’s performance. Therefore, as previously noted, this ratio is typically known as the return on ordinary shareholders’ equity or return on common stockholders’ equity ratio. Because shareholder equity is equal to a business’s assets minus its debts, ROE can also be considered the return on net assets.