What Is a Good Return on Equity and What Does It Tell Us?
Updated · Oct 25, 2022
The most important step of investing is the choice of stocks. To make good decisions, you have to learn how to evaluate business performance.
And while financial standing is a key indicator, you also need to be able to foresee growth potential.
But what is a good return on equity?
Read on to find out.
What Does ROE Mean?
ROE stands for return on equity. It’s a measure of financial business performance and management efficiency.
Let’s further break down the concept to explain how that works.
The definition of ROE is the earnings a company has generated (return) using the shareholders’ investment (equity).
The first part of the definition is the return. It is measured as net income before dividends and after expenses.
Equity has several meanings. In this case, it refers to the shareholders’ investment in the company. The simplest way to calculate it is by subtracting all liabilities from all assets.
So, investors buy shares in a company. The company uses that money to grow and cover expenses. If it distributes the funds effectively, the income increases.
And that’s the meaning of return on equity—the growth compared to the investment.
How to Find ROE
As we mentioned, to calculate ROE, you need to find the net income and shareholders’ equity.
After that, you just apply the return on equity formula:
ROE = net income / shareholders’ equity
ROE is typically expressed as a percentage, so you can multiply the result by 100.
Note that you cannot calculate ROE if the net profit or equity is negative.
What Is a Good Return on Equity?
Now that you know what ROE means and how to calculate it, let’s see how to interpret it.
According to most experts, a good ROE is somewhere between 15% and 20%. That said, you should take this as a very rough estimate.
The numbers vary greatly between industries. What is considered a high ROE in one sector may be low in another. So, you should compare only businesses from the same sector.
Even then, you’ll find big fluctuations, which could mean a lot of things.
Like other financial metrics, the return on equity ratio is prone to biases. This doesn’t mean it isn’t reliable. On the contrary, experts like Warren Buffett claim it’s the best indicator of business performance.
But you do need to use it in conjunction with other metrics to get the entire picture.
More importantly, you have to learn how to recognize potential issues. As long as you understand where they come from, you can use them to your advantage.
Here’s what you need to look out for.
Limitations of ROE
- The type of dividends paid affects the ROE formula. With cash dividends, equity decreases, and ROE increases. Stock dividends are reinvested in the firm, so they don’t have that effect. So, check what’s included in the calculation and the balance sheet.
- A recent increase in assets (e.g., gathered through equity funding) will lower the ROE temporarily. As such, you should always look at changes over the course of several years. Consistent returns are a good indicator of future performance.
- ROE goes up if the company takes on debt. Why? Because the equity formula includes both assets and liabilities. If the latter increases, equity decreases, and ROE goes up.
- ROE isn’t the only factor that matters. Even if the growth is exceptional, if the price of the stock is high, it may not be worth it. A moderately high ROE and a lower stock cost are the dream combo.
What Is a Good Application of ROE?
- ROE is great for evaluating mature, stable businesses. It can help you identify well-managed, solid organizations. It isn’t as reliable with growing companies, though.
- You can use it to identify potential issues within a business. For example, an unrealistically high return on equity could mean that the company has taken on a huge debt recently.
- You can use ROE to estimate sustainable growth rates. Sure, high returns are attractive.
But has the company maintained it at this level over the years, or is it a one-time occurrence?
If you see a business that outperforms others in the industry by a large margin, investigate why that might be before investing in it.
- To calculate potential future dividend increases, multiply the ROE by the payout ratio (dividends). Again, compare it to the industry average to check if it’s sustainable or is calling for an investigation.
ROE is a financial business performance measure. It is also a great indicator of growth potential and management efficiency.
But to get all that information, you need to understand how it works. It isn’t enough just knowing what a good return on equity is.
Like other metrics, ROE is prone to biases. But if you can interpret it, you can use that to your advantage.
With an eye for research, Aleksandra is determined to always get to the bottom of things. If there’s a glitch in the system, she’ll find it and make sure you know about it.