ROE – Return on Equity

Return on Equity slightly differs from ROA. The return on equity (ROE) is a performance indicator that is computed by dividing net income by shareholders’ equity. The return on ROE shows how profitable and efficient a company is at making money for its shareholders. When calculating the ROE, a similar action needs to be taken into consideration –  always make an industry comparison and do not compare the results of one company to different sectors.

What is typical for a stock’s peers determines whether a return on equity is good or bad. Utilities, for example, have a lot of assets and debt on their balance sheet compared to a small portion of net income. In utilities, a typical ROE might be as low as 7-10%. A company in technology with smaller balance sheet, the net income may have an average ROE of 15% or more. A good rule of thumb is to try to get a return on equity  a little bit higher than the average for the industry.

A high return on equity isn’t always beneficial. A high ROE could indicate various issues, including irregular income or a large debt. Also, a company with a negative ROE because of a net loss or negative shareholders’ equity can’t be judged or compared to a company with a favorable ROE. Much more about shareholders equity and key ratios you can find here. I.e. companies with a small portion of Equity in the balance sheet can produce misleadingly high ROE, due to small share on the balance sheet.

If the equity = 1 000 000 USD (100% of balance sheet, thus no debt) and Net Income is 100 000 USD, then, ROE = 100 000 / 1 000 000 = 10%. However, if the balance sheet on the liability side is funded mainly via debt and equity reached just 300 000 USD, then with the same net income the result will be =100 000 / 300 000 = 33%, thus “misleadingly” high. Be aware of that.

PayPal’s ROE stands at an excellent 16.8%, while Alibaba’s ROE is at 6.4%. However, it is not a good idea to compare Paypal and Alibaba in this way due to high sector imbalances.