Return on equity (ROE) measures the income generated by entity against each dollar of stakeholders invested in entity’s residual interest or equity. In simple words, ROE determines net income generated by entity on its equity capital. Return on equity is also named as return on net worth (RONW).
ROE is calculated using the formula:
| Return on Equity (ROE) = | Relevant net income |
| Average equity |
Equity is simply the shares representing entity’s ownership and include; ordinary shares held by majority and minority interest a.k.a non-controlling interest and preference shares if they carry voting and other important equity related characteristics.
Most often preference shares are not considered part of equity as holders of such shares do not have voting rights. In such situation calculation of average equity will not include preference shares.
Due to these factors, it is important to understand that only such income be taken as numerator of ROE ratio that relates to equity value under consideration. If there both ordinary and preference shares carry equity rights then in such case relevant net income will be profit after tax as this is amount available to ordinary and preference share holders for distribution.
| Return on Equity (ROE) = | Profit after tax |
| Average equity |
However, if preference shares are not part of equity then they excluded from average equity calculation and also relevant returns will be net of profit after tax and dividends on preference shares.
| Return on Equity (ROE) = | Profit after tax – dividend on preference shares |
| Average equity |
Average equity is usually calculated using simple average technique i.e. adding opening (start of the year) and closing equity (end of the year) and dividing the sum by 2.
However, entity may use other methods to calculate average equity e.g. weighted average technique. Benefit of using weighted average technique over simple average technique is that former technique considers number of shares and the relevant period of time. For example if entity has issued new shares at the start of last quarter of its financial year then weighted average is done as following:
| Opening equity | X | 9 | = | ### |
| 12 | ||||
| Closing equity | X | 3 | = | ### |
| 12 | ||||
| Weighted average number of shares | = | ### | ||
Analysis and interpretation
Just like other profitability ratios, higher the ROE the better as it indicates that entity has managed to generate higher returns by better utilizing the investment made by stakeholders. As with every other ratio, for better understanding and if entity has improved or regressed, users have to compare the results of ROE with certain benchmark like last year’s ROE, budget ROE, competitor’s ROE or industrial average ROE.
To improve ROE entity either has to:
- increase net income generated during the period or
- reduce average equity during the period.
Better and favourable option is to increase entity’s net income. Net income is utilizes most of the time know strategies to cut down on expenditures starting with non-developmental expenditures like administrative expenses and interest expenses etc.
Decreasing equity capital is considered a last resort option. Although it will increase ROE figure and sometimes it is a logical option for entity, but can have undesired consequences as investors may take this as a signal that entity is without cash or facing financial crises and has no solution to implement for near future thus reducing equity capital to maintain ROE. This is usually done by share-repurchase or buy-back.
As one can observe, influencing ROE figures by manipulating figures especially as a result of capital alteration, ROE is considered volatile and must not be solely relied upon. For better analysis of entity’s profitability, one must consider the overall effect of these ratios by taking all of profitability ratios together.