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Learn how to calculate the return on equity accurately. Understand why it is an important metric for evaluating a company’s financial efficiency.
Return on Equity (ROE) is one of the most widely used financial ratios to assess how efficiently a company uses equity to generate profits. For retail investors, ROE serves as a valuable indicator of management's ability to deliver returns on capital.
Recognising the strengths and limitations of this ratio is valuable whether you are new to stock market fundamentals or seeking to deepen your financial knowledge. It helps you asses the company’s growth potential and the risk of holding its shares.
ROE measures how much net income a company generates as a percentage of shareholders’ equity. It is a financial metric, expressed as a percentage, comparing a company’s net profit to the equity invested by shareholders. ROE shows how effectively a company uses investors’ funds to generate income.
For instance, a company with an ROE of 15% generates ₹15 in profit for every ₹100 of equity. This ratio is beneficial when comparing companies within the same sector. Different industries have varying capital structures, making ROE a helpful tool for evaluation.
Understand how to find return on equity using a simple formula, and see how to apply it.
ROE = Net Income / Shareholders’ Equity
Net Income is the company’s profit after taxes, shown at the bottom of the income statement
Shareholders’ equity is the capital invested by shareholders plus retained earnings found on the balance sheet
Calculation of shareholders’ equity: Shareholders’ Equity = Total Assets – Total Liabilities
Consider a company with a net income of ₹5,00,000 and shareholders’ equity of ₹25,00,000.
This indicates that the company generated a 20% return on shareholders’ capital during the year. You can even use a return on equity calculator for simple and easy computation.
Check out what what a high, low, or negative ROE indicates about a company’s financial health:
A high ROE often indicates efficient management and profitable operations. However, it must be compared within the industry and across multiple years. This helps you assess sector-specific capital requirements and identify risks associated with high leverage.
A low ROE may suggest an underutilisation of capital or poor profitability. It could also indicate that the company is not reinvesting earnings effectively or is facing operational inefficiencies.
A negative ROE arises when a company has net losses or negative equity, generally regarded as a negative indicator and requires deeper analysis. This can result from factors such as significant one-time expenses, restructuring charges, or operational challenges.
Note that it is important to avoid judging a company based on a single ROE value. Always consider trends, industry comparisons, and other financial ratios.
DuPont Analysis decomposes ROE into three key components: profitability, efficiency, and leverage. This breakdown can help you understand whether a high ROE is driven by better profit margins, efficient asset utilisation, or increased financial leverage.
Check out how to calculate the return on equity using the DuPont Analysis with an example:
ROE = Net Profit Margin × Asset Turnover × Equity Multiplier
Net Profit Margin = Net Income / Revenue
Asset Turnover = Revenue / Total Assets
Equity Multiplier = Total Assets / Shareholders’ Equity
Assume a company has:
Net Profit Margin = 10%
Asset Turnover = 1.5
Equity Multiplier = 2
Then,
Return on Equity (ROE) measures how efficiently a company generates profit using shareholders’ funds. While what's considered "ideal" can vary by industry, a ROE of 15% to 20% or higher is generally seen as strong and healthy.
A high ROE indicates that the company is using its capital effectively to grow profits, which is appealing to investors. However, a very high ROE might also signal excessive debt or non-sustainable earnings—so it's important to compare it within the context of the industry average and alongside other financial metrics.
ROE is a helpful metric, but it is not foolproof. It should be interpreted with caution and considered alongside other financial indicators for a comprehensive understanding. Some limitations include:
Companies with high debt may have inflated ROE figures because borrowings reduce the equity base. As a result, a company may appear more efficient than it actually is in generating returns from shareholders’ funds.
When companies repurchase shares, they reduce the number of outstanding shares and the equity on their balance sheet. This can artificially inflate their ROE, giving a misleading impression of improved performance even when net income remains unchanged.
Different capital requirements across industries can make direct ROE comparisons misleading. For instance, asset-light sectors may naturally report higher ROE than capital-intensive ones.
ROE does not account for business or financial risks. Two companies with the same ROE may have vastly different risk profiles depending on factors such as leverage, market volatility, or competitive pressures.
Rate of Return (RoR) refers to the percentage gain or loss made on an investment relative to its initial cost. It applies broadly to all types of investments—such as stocks, mutual funds, real estate, or bonds—and is calculated using the formula: (Gain or Loss / Initial Investment) × 100. It helps investors evaluate how profitable their investments have been over a period of time.
On the other hand, Return on Equity (ROE) is a financial ratio that measures how efficiently a company uses shareholders' equity to generate profit. It is specifically used to assess a company's performance and is calculated as: (Net Profit / Shareholder’s Equity) × 100. Unlike RoR, which can be used for any asset, ROE is used primarily by analysts and investors to evaluate how well a company is managing its capital to deliver returns.
In summary, RoR is a general performance measure for investments, while ROE is a company-specific profitability metric.
ROE is a powerful tool for analysing how efficiently a company uses its shareholders’ capital. By using net income and equity from financial statements, you can gain a clearer view of profitability. Always evaluate ROE in context, considering industry standards, debt levels, and long-term trends.
Supplementing ROE analysis with tools such as the DuPont method can provide deeper insights. Understanding its limitations ensures a more well-rounded approach to evaluating a company’s performance.
This content is for informational purposes only and the same should not be construed as investment advice. Bajaj Finserv Direct Limited shall not be liable or responsible for any investment decision that you may take based on this content.
To find return on equity, you can use the formula: ROE = (Net Income / Shareholders’ Equity) × 100. You can find net income in the profit and loss statement and shareholders’ equity in the balance sheet.
There’s no fixed number. A ‘good’ ROE depends on the industry. Generally, a higher ROE compared to industry peers is favourable.
Not necessarily. A high ROE could result from high leverage or a shrinking equity base. It must be analysed in context.
Yes. More debt can reduce shareholders’ equity, increasing ROE even if profits haven’t changed. This can give a skewed view of performance.
A negative ROE typically indicates losses or negative shareholder equity. This may result from consistent losses or significant liabilities.
ROE and ROA both measure different things. ROE focuses on returns for shareholders, while ROA shows how well a company uses its total assets to generate profit.
You can find the ROE data for a company in its annual report, stock exchange filings (such as from the NSE or BSE), or financial databases.
