ROE - Return on Equity

 

What is ROE ?  

 

The Return on Equity (ROE) expresses the degree of remuneration of shareholders for their capital invested into the company.

This ratio expresses the measurement of the return on the investment of the members (resources that over time they have made or left – not withdrawing profits – in the company, that is, of the net worth.

The ROE is therefore an indicator of global profitability, let's say of the overall profitability obtained by the company, summary of all the management areas (operational, financial, ancillary, tax) that have contributed to the operating result; an indicator, in short, of the degree of risk remuneration faced by the entrepreneur or the partners.

 

                            

 

This static approach of analysis determines a value that is given by the ratio of net operating income (net profit) to net worth indicating the profitability of the own assets used by the property for the operation of the business. However, it is inevitable that ROE will be at least higher than the return on risk-free investments (such as government bonds) for a potential investor to see their participation as positive. This indicator values in percentage terms the degree of remuneration in favour of shareholders for the capital invested by the company in the company.

 

The community of creditors might be more interested to obtain a dynamic ROE that uses an average value to the denominator between the beginning of the year and the end of the financial year. This is because in order to ascertain the profitability of the company's equity (own assets or equity) it is more correct to average the initial value with the final value of the equity.

 

 

FINANCIAL LEVERAGE ANALYSIS

 

The financial leverage is used to measure the financial risk that arise from the presence of debt and/or preferred sticks in the company's capital structure.

The ROE is used in the financial leverage analysis as it helps to understand what could be the optimal policy of composition of funding sources (financing capital) that have been able to meet the financing requirements generated by the capital employment structure. Especially in understanding the multiplier effect that is underlying the structure of the enterprise.

In this regard, it is very important to understand one of the most prominent debt ratio that is generally identified as DEBT EQUITY RATIO and understood as the ratio of total third-party assets to equity and that it is included in the following formula: ROE = ROI + (ROI - i) * D/E which can be extended into the following formula in consideration of other influences coming from corporate income taxes.

 

 

 

 

IMPROVING STOCKHOLDERS RETURNS

 

It is generally known that a high level of management performance like it is when the ROI is above average, it produces a high return to equity holders. However even a poorly managed company that has ROI under average and suffer of low performance, it can produce above average return to stockholders' equity (ROE).

This can be achieved through borrowed funds that according with the DU PONT formula on ROE we can measure with the equity multiplier.

As we can see above, the formula ties the company's ROI and its degree of financial leverage which is the actual use of borrowed funds in a certain moment in time.

Within the formula arise the "equity multiplier" which gives an indication of the extend to which a company asset is financed by stockholders or by third party funders. In fact when the "equity multiplier" is equal to 1 the ROI and the ROE are the same. Differently, when the company has a financial leverage due capital supplied by creditors which is equal to (1 - Debt ratio). 

It must always be considered that for  the Return on Equity, there are no optimal values. To this purpose is always useful to compare the ROE with comparable or other's company operating in the industry finding it with a compelling benchmark analysis. In fact, the ROE cannot ignore the reference sector as it must be sufficient to reward both the general risk of carrying out the business as well as the specific risk associated with the characteristics of the reference sector.

If there are significant changes in equity from one year to the next (revaluation reserves, increased share capital, assets contribution for future capital increases by shareholders), it could be misleading to use the ROE indicator, this can be monitored with the Change in equity ratio

 

 

 

 

 

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