Understanding how effectively a company uses its shareholders’ investments is a key aspect of evaluating its potential as an investment. Thankfully, there’s a metric that provides this insight: Return on Equity (ROE).
It offers investors a unique lens to evaluate profitability, operational efficiency, and management’s ability to create value.
So, what is return on equity, how is it calculated, and why do investors look at it?
What Is Return on Equity (ROE)?
Return on Equity (ROE) is a financial metric that measures how effectively a company uses its shareholders’ investments to generate profits. It is expressed as a percentage and is often looked at by investors when assessing a company.
Like return on invested capital (ROIC), return on equity is a returns metric. It represents the profits generated from investing capital (equity for ROE and invested capital for ROIC) into a business.
Since equity is the remaining value of a company’s assets after deducting liabilities (the company’s net assets), return on equity is sometimes called return on net assets.
Return on Equity Formula
Return on equity is one of the simplest returns metrics to calculate. The formula is straightforward without any additional complex calculations.
Net Profit
Net profit, or Profit after tax, is taken directly from the company’s statement of profit or loss (income statement). It represents the remaining revenue after all expenses are accounted for.
Average Shareholders’ Equity
This is the average of the company’s total shareholders’ equity for two consecutive years. To calculate a company’s 2020 return on equity, you would divide its 2020 profit by the average of its 2020 and 2019 shareholders’ equity.
Shareholders’ equity is taken directly from the company’s statement of financial position (balance sheet).
ROE Calculation Example
To illustrate how return on equity is calculated, we’ll use financials from Microsoft (Source: QuickFS).
Table 1: Microsoft’s 2022 – 2024 Financials (in millions of $)
| 2022 | 2023 | 2024 | |
| Net Profit | 72,738 | 72,361 | 88,136 |
| Shareholders’ Equity | 166,542 | 206,223 | 268,477 |
One component of the formula is ready to go (net profit). We only need to calculate Microsoft’s average shareholders’ equity to put the formula together. Table 2 shows how that’s done.
Table 2: Calculating Microsoft’s Average Shareholders’ Equity
| 2022 | 2023 | 2024 | |
| Shareholders’ Equity | 166,542 | 206,223 | 268,477 |
| Average Shareholders’ Equity | – | 186,383 | 237,350 |
Average Shareholders’ Equity (2023) = (166,542 + 206,223)/2
Average Shareholders’ Equity (2024) = (206,223 + 268,477)/2
Now that all components are ready, we can calculate Microsoft’s 2023 and 2024 return on equity in Table 3.
Table 3: Calculating Microsoft’s Return on Equity
| 2023 | 2024 | |
| (A) Net Profit | 72,361 | 88,136 |
| (B) Average Shareholders’ Equity | 186,383 | 237,350 |
| = ROE (A / B) | 38.8% | 37.1% |
Microsoft’s 2023 and 2024 returns on equity were 38.8% and 37.1%, respectively. In other words, Microsoft generated $38.80 and $37.10 in profit for every $100 investors contributed to the company in those years.
Why Investors Look At ROE
ROE can be used to evaluate a company’s profitability and efficiency – how effectively it uses its shareholders’ investments to generate profit. Besides this, investors look at ROE to assess a company’s management team, compare companies and potentially find undervalued opportunities.
Assessing A Company’s Management Team
Capital allocation is a fundamental trait all successful companies possess.
Companies like Visa, Mastercard, Apple and Microsoft (some of the most successful companies today) have high returns on equity. For example, Visa’s 2024 ROE was 50.7% – every $100 of equity invested in the company yielded $50.70 in profit.
A high return on equity suggests that management effectively allocates shareholders’ equity to profit-generating business investments. Investors are often drawn to these kinds of companies – companies with a team of competent capital allocators.
When assessing a management team, ROE should be used alongside return on invested capital (ROIC) and return on capital employed (ROCE). Together, these metrics provide a holistic view of management’s capital-allocating qualities.
However, assessing how effectively management allocates capital is only one piece of the puzzle. Investors should also examine the management team’s capital distribution record (dividend payments and share buybacks), compensation and tenure length.
Comparing Companies
Since ROE represents the return on (shareholder) equity, investors often determine a company’s attractiveness based on this return.
A company’s ROE might be the differentiating factor if an investor is trying to decide between two companies to invest in. A consistently high ROE can suggest higher returns for the investor as the profit generated on their investment (shareholders’ equity) is higher.
Like most metrics, return on equity should be used to compare companies in the same industry because they have similar capital requirements (the funds needed for operations).
For example.
Comparing Mastercard (2023 ROE of 167%) and Walmart (2023 ROE of 18%) based on return on equity isn’t a fair comparison. Although the two companies are successful in their respective fields, the comparison isn’t justified – Mastercard sells services (high-margin, capital-light business), and Walmart sells physical products (low-margin business) through brick-and-mortar stores (capital-intensive).
Quick explanation.
- High-margin, capital-light businesses generate significant profits with minimal investment in physical assets.
- Low-margin, capital-intensive businesses require significant physical asset investment and operate with tight profit margins (they turn less revenue into profit).
To drive this point home, Mastercard’s 2023 net profit margin (the percentage of revenue the company keeps after accounting for all expenses) was 44.6%. Walmart’s was 2.4%. For every $100 of revenue, Mastercard retained $44.60 after deducting all costs versus Walmart’s $2.40.
The two businesses are incomparable.
Finding Potential Undervalued Companies
When used with other metrics, return on equity can aid in identifying potentially undervalued companies.
A company with a consistently high return on equity and a low price-to-earnings ratio can signify that the market is underappreciating its profit-generating abilities, thereby mispricing its stock. This could allow investors to pick up cheap shares in a quality company before the market realises it, starts buying in, and pushes the price up.
But there is a caveat. The company’s low valuation could be warranted.
Even if the company generates above-average profits on the equity invested, it could be maturing – growth could be slowing. The market may recognise this and disregard the company’s high ROE.
This combination of high ROE and low valuation may lure investors into a ‘value trap’: buying into a company because it seems undervalued when, in actuality, it is fairly valued based on its low growth prospects.
Metrics don’t always paint the entire picture of a company. So, it’s always best to value companies and read their annual reports to get as much information as possible before investing.
What Is A Good ROE?
A good return on equity is subjective and dependent on the following factors (not an exhaustive list).
Investor Preferences
Some investors think a 20% return on equity is high, while others may think it’s too low.
Capital Requirements
Capital-light businesses tend to have higher returns on equity than capital-intensive ones because of their lower operating costs and higher net profits.
Company Product Type
Software businesses tend to have high returns on equity, while physical goods companies have lower ones.
Summary
Return on Equity (ROE) is a widely used investing metric because it shows a company’s ability to turn shareholder investments into profits. Whether assessing management’s capital allocating abilities, comparing companies within the same industry, or uncovering undervalued opportunities, return on equity is an indispensable tool for investors.
However, using ROE (and other metrics) in isolation poses a risk: it doesn’t always tell a company’s full story. Using ROE alongside other metrics and a thorough analysis of the company’s financials is essential to making well-informed investment decisions.
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