Return on equity is one of the most popular financial performance indicators. It tells investors exactly how efficiently a firm’s management team uses their money to generate profit.

Generally speaking, the higher the return on equity, the better. However, this metric can be easily manipulated by businesses, misleading investors. Fortunately, there are several tricks to check for this sort of behaviour. Let’s take a closer look at this financial metric, explore how to calculate it, and discover where the limitations lie.

What is Return on Equity (ROE)?

By definition, the Return on Equity, or ROE, measures a management team’s effectiveness in generating profits from shareholder equity.

This ratio combines information from the income statement and the balance sheet. Both financial statements can be found in an annual report or quarterly trading update. However, the timing of these financial statements needs to be taken into account.

The income statement, or profit and loss statement, records revenues, costs, and profits over a specified time period. By comparison, the balance sheet states the recorded values of a firm’s assets and liabilities at a single point in time.

Therefore, instead of using the reported figure for equity, analysts should calculate the average equity value over the time period of the selected net income figure. This provides a more accurate measure of Return on Equity.

ROE Example

XYZ Corp recently reported its annual results for the year ending 31 December 2022. The company recorded net earnings of $5m on the income statement. And under the balance sheet, the company had a total of $100m in shareholder’s equity at the start of the 12-month period and $150m in equity at the end of the period.

At an ROE of 4%, the company is generating $1.04 in value for every dollar of shareholder’s money.

What is a good Return on Equity?

Every industry is different. Therefore, there is no universal threshold at which return on equity can be considered good or bad. Instead, investors need to compare a company’s ROE with its peers or industry.

Going back to the previous example, if the ROE of XYZ Corp’s rivals is 6% on average, then it’s reasonable to say that the company’s management team doesn’t appear as skilful as its competitors. Therefore, XYZ Corp may not be the best way to invest in a particular sector.

However, further investigation is required when stumbling across a company with a significantly higher ROE than its peers. That’s because there are numerous ways that this metric can be inflated. For example, a company that has negative shareholder equity and negative net income can still end up with a positive and high ROE that’s meaningless and can mislead investors.

One-time windfalls can also inflate return on equity. A company that has consistently suffered losses for several years in a row will often see the reported value of shareholder’s equity steadily fall. However, should this business suddenly gain a one-time windfall of profits, the surging value of net income paired with the depressed value of equity can send the ROE skyrocketing.

Lastly, ROE can be influenced by the level of debt a business has. A firm that borrows aggressively will end up with a large pile of loan liabilities on its balance sheet. As the company borrows more money, the value of equity drops, pushing the return on equity up. Investors that don’t identify this trend can be misled into thinking a business is run by geniuses when it’s actually on the path to bankruptcy.

Limitations of ROE

As I’ve just highlighted, a high Return on Equity isn’t always a positive sign. And in some cases, it can actually signal investors to steer clear. But assuming a calculated ROE figure isn’t manipulated by management, it’s essential to know the limitations of this financial metric.

• Accounting Methods – A high ROE value that isn’t driven by excessive debt or one-time gains may still be inflated through aggressive accounting practices. When comparing the ROE of two companies, investors need to investigate any differences in how equity and profits are reported.
• Negative ROE – A negative ROE or an ROE calculated with negative equity and negative net income is meaningless.
• Comparisons – This metric cannot be used to compare different businesses operating in different industries.

Because of these limitations, Return on Equity should be combined with other efficiency ratios to determine the quality of a business.

The Return on Invested Capital (ROIC) is a popular alternative. Why? Because unlike ROE, Return on Invested Capital isn’t affected by a firm’s capital structure.

What is DuPont analysis?

An investment analyst investigating the drivers of a firm’s Return on Equity may use a technique called DuPont analysis. This is a method of breaking ROE down into its base components to gauge better what’s going on under the surface. And it can help create a clearer picture of a business’s profitability, leverage, and capital efficiency.

The basic 3-Part DuPont model equation is:

However, this can be extended further into the 5-Part Dupont formula:

Where EBT is the earnings before tax, and EBIT is earnings before interest and tax. It’s also worth noting that the financial leverage ratio is also sometimes known as the equity multiplier.

The bottom line

Return on equity is a key metric investors use to evaluate how effectively a company is using shareholder money. However, it should never be taken at face value. And analysts need to spend time investigating whether ROE is accurate and what’s driving it.

This article contains general educational information only. It does not take into account the personal financial situation of the reader. Tax treatment is dependent on individual circumstances that may change in the future, and this article does not constitute any form of tax advice. Before committing to any investment decision, an investor must consider their individual financial circumstances and reach out to an independent financial advisor if necessary.