ROE

What it means

ROE, return on equity, is a ratio showing how much net profit a company generates from each euro its owners have put in. It is calculated as net profit divided by equity, usually the average for the period, and expressed as a percentage.

For owners, ROE is one of the most important ratios because it shows the return on their investment. They compare it with what they could earn elsewhere for similar risk, for example in other companies or on the capital markets.

ROE is linked to ROA through financial leverage. Under the breakdown known as DuPont, ROE equals profit on sales, times asset turnover, times the ratio of assets to equity. A high ROE may therefore stem from a good margin, efficient use of assets or high debt.

How it works in practice

In financial analysis we always break ROE down into its components. The client can then see whether higher ROE comes from better profitability or merely from the company paying out dividends, reducing equity and increasing debt. The latter means higher risk, not better performance.

We also use ROE when deciding on profit distribution. If the company achieves a high ROE and has somewhere to invest, retaining profit may bring owners more than paying dividends. If ROE is falling, a payout may be more sensible.

In a business valuation we compare ROE with the cost of equity. A company whose ROE consistently exceeds the required return creates value, which shows up in a higher price on sale.

What to watch out for

With very low or negative equity, ROE comes out extremely high or meaningless. In such cases we do not use the ratio and instead look at absolute profit, ROA and the company’s financial stability.

One-off gains, such as from selling assets, can push ROE sharply higher in the short term. When comparing years we therefore also use an adjusted ROE excluding exceptional items to show underlying performance.