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Return on equity is a financial measure that indicates the company’s profitability relation to the shareholders equity. In other words, it measures the company’s efficiency in generating profits for the shareholders.
Return on equity is calculated by dividing the company’s net income, that can be obtained from the reported income statement, by the shareholders equity, that can be obtained from the balance sheet. Shareholders equity is the difference between the company’s assets and its liabilities. It is also the capital that shareholders inject into the company plus the accumulated retained earnings.
ROE =Net income / Shareholders equity
Why is ROE an important metric?
ROE is a widely used measure to know how efficient the company is in generating profits in relation to its shareholders equity. In general, higher ROE means that the company is efficient in managing its capital and making reasonable returns on its shareholders.
ROE can be used to estimate the future growth rate for a company. The growth rate can be calculated by multiplying the ROE by the company’s retention ratio (the percentage of the company’s net income that’s retained & reinvested).
So, if a company ROE is 15% and it keeps 20% of its earnings retained. Then the future growth rate estimate is 3% (15% * 20%). This metric is more important for growth investors.
Dividend Growth Rate
While growth investors prefer “growth rate”, other investors who prefer dividends gains will prefer the dividend growth rate.
Dividend growth rate can be calculated by multiplying the ROE by the dividend payout ratio (The percentage of earning that’s distributed as dividends) . For a company that has 15% ROE & distributes 30% of its earnings. The dividend growth rate would be 4.5%
Take into consideration
Even though a higher ROE is better, it’s not always the case. A significantly larger ROE can be an indicator of a weakness point in the company.
Too much debt
Having a high debt-to-equity ratio can increase the return on equity, which is preferable if it is a reasonable number and the company is stable at generating positive cash flows. Having too much debt will significantly increase the ROE but the company will be in a risky position. High ratios without a strong justification should make you alert.
If a company had been incurring losses for several years, each loss would be deduced from the total shareholders equity. When the company turns profitable, the ROE would be high as the ratio is calculated over a low equity, affected by the previous year losses, which makes its ROE misleadingly high.
For example if a company had EGP 100M in shareholders equity and has incurred losses for 4 years at EGP 10M per year, the shareholders equity would be 60M (100 – 4*10). When the company starts making profits again, the ROE will be calculated on the deduced shareholders equity, which will inflate the ROE without reflecting the performance of the company.
What is a good ROE?
Intuitively, the Return on Equity reveals the ability of management to generate a rate of return that is higher the minimum rate of return required by investors – the so-called cost of equity (COE). In Egypt, a rule of thumb COE is around 15-20% so a sustainable ROE above 20% is a major boost to value.