Stakeholders hold the key to start a business and make way for its growth. That is why certain tools are employed to help them make decisions that can significantly affect the business. They need to have a detailed vision of the performance of a business. Many financial ratios can help a stakeholder understand the performance of a business. One of those profitability ratios is return of equity (ROE).

How Does Return On Equity (ROE) Help Stakeholders?

The return on equity ratio is a helpful tool for shareholders to determine if the business is good at generating returns from the shareholders’ investments. The ROE can reveal if the firm can effectively utilize its investments to earn additional income for the company.

After computing the return of equity of a business, shareholders will be able to determine how much the return of their investment is compared with the business’s net income.

Investors typically consider the S&P 500 long-term average of 14% as the benchmark for an acceptable return on equity ratio. Anything less than 10% would be considered a poor investment.

Being that shareholder’s equity is equivalent to a company’s assets minus debt, ROE is similar to the return on net assets.

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Cannot Decide Which Stock To Invest In?

Some investors are yet to choose which business to invest in. The return on equity ratio is a relevant tool for investors to compare a company with another.

Since the return on equity ratio identifies the relationship of a company’s net income with its value in the business, it helps future investors make comparisons between similar stocks. It means that prospecting investors can first compare the ROE of different stocks to determine the return of the investments made by the current shareholders of each company. This helps them generate profit by finding the stock that can provide them with the maximum return for their investment.

The ROE Formula

The return on equity formula is computed using the net income and stakeholder’s equity, all obtained from the income statement and balance sheet, respectively. It is calculated by taking the net income made over a given period and dividing by the average stockholders’ equity financing invested in that time.

Return on Equity = Net Income / Average Shareholder Equity (SHE)

EXAMPLE

A company had a net income of $ 1,800,000 during the year ending June 30, 2020.The shareholders’ equity on July 31, 2019, and June 30, 2020, was $10,000,000 and %15, 000,000, respectively. The ROE for the year ending June 30, 2020, is?

Solution

Average SHE = (10,000,000 + 15,000,000) / 2 = 12,500,000

Return on Equity = $1,800,000 / $12, 500,000 = 14.4%

ROE is Computed, What Now?

If the computed ROE is 1, it means that the return on every shareholder’s value in the balance sheet is 1. For an existing shareholder, the ROE shows the business’s additional income for every 1 value of a shareholder’s investment with the company.

For a potential investor, the ROE computed in a particular stock can give an outlook of what their investment in the company can earn. Comparing the different ROEs of various stocks can help potential investors determine which company can generate more income. It can also be a great tool in identifying which business has the potential to grow their cash flow with their investment.

In comparing the ROE of various businesses, the prospective investor gets to find out which firm is capable of growing faster than its competition. Companies with better ROEs than their competitors can make potential investors believe that those businesses can generate higher earnings than their competitors.

ROE ratios vary across different industries or sectors. Some industries will have higher ROE ratios while others low. This means investors must compare ROE ratios within each given industry and cannot compare a company with another company outside that sector.

Keys For The Return on Equity Ratio (ROE)

The net income of a business can be sourced from its income statement. The income statement shows the profits or loss earned by the firm from its current operations. It means that the income statement reveals if the business’s expenses were higher or lower than the firm’s revenues for a certain period.

The revenues reported in the income statement can include the income from their operations, interest payments, income from rent, and other sources of income. Also, the expenses that are included in the income statement can be the cost of goods sold, salary expense, rent expense, and tax expense.

The net income is computed by subtracting the total expenses from the total revenues of the company.

A negative net income would mean that the company encountered a net loss or the expenses exceeded the current period’s revenues.

A positive net income means that the company’s expenses were less than the current period’s revenue.

The return on equity ratio can only be computed for decision-makers if the net income is positive and the shareholder’s equity is also positive.

The balance sheet shows the relationship of a firm’s assets, liabilities, and shareholder’s equity. The balance sheet can reveal a lot about a business.

One of the crucial things that a balance sheet can reveal is the net worth of a business. The net worth of a business can be computed by reducing the business’s total assets with the total liabilities. The net worth is also equivalent to the shareholder’s equity portion of the balance sheet.

The balance sheet has three portions, the asset portion, the liability portion, and the shareholder’s equity portion.

The balance sheet’s asset portion shows the value of the company’s resources and anything valuable to the company. These assets can help a firm earn revenues.

The liabilities portion of a balance sheet shows the total amount that the company needs to pay its creditors.

The shareholder’s equity portion of a balance sheet reveals the total value of the business’s shareholders.

The three portions of the balance sheet show the business’s financial position at a certain point when the financial statements are dated.

Why ROE is A Necessary Tool To Stakeholders?

The return on equity ratio is an essential tool to help stakeholders make sound decisions.

The ROE can help shareholders determine how efficient a company is at generating income from their investments.

For stakeholders, the ROE can serve as a tool to help them decide which stock has the potential to grow if they put their idle funds in that company.

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Chris Douthit
Chris Douthit

Chris Douthit, MBA, CSPO, is a former professional trader for Goldman Sachs and the founder of OptionStrategiesInsider.com. His work, market predictions, and options strategies approach has been featured on NASDAQ, Seeking Alpha, Marketplace, and Hackernoon.