Return on Equity (ROE) – Meaning, Formula, Assumptions and Interpretation

Return on Equity (ROE) is probably the most important number in the financial universe. Every company is driven by profit and Return on Equity (ROE) is considered to be the best indicator of the profitability of a company. Debt holders just want to get their interest and principle back i.e. they will obtain a fixed rate of return. On the other hand equity holders get a variable return. For this reason, this number is considered more important than Return on Assets or Return On Invested Capital.

Formula

Return On Capital Invested = Profit After Tax (PAT) / Equity

Return on Equity (ROE) is one of the few ratios that uses after tax profits

Meaning

Return on equity tells the shareholders how many dollars of post-tax earnings, the company generated for every dollar of equity capital it had.

Assumptions

• No Dilution: The Return on Equity (ROE) figure does not take into account the outstanding share warrants. This is because there is uncertainty as to whether the derivate products will be exercised and whether the equity base of the company will change. However, if warrants are exercised and equity is diluted, the ROE figure could change drastically.

• Leverage to Continue: The return which is being compared against equity has been generated by using debt too. The Return on Equity (ROE) ratio assumes that the current gearing ratio i.e. leverage of the firm is likely to continue in the future. Moreover Return on Equity (ROE) may go up or down because of a change in leverage alone. ROE going down could be a good sign too because it would mean de-risking of the company.

• Taxation to Continue: The Return on Equity (ROE) also assumes that the taxation structure will remain the same in the future. If comparisons are being made with past ROE’s then there is an implicit assumption that the tax structure has not changed.

Interpretation

• Valuation Multiple: ROE is the most widely used ratio for valuation of a firm. Equity investors are interested in the earnings that the firm will generate for them. ROE provides a direct measure. Therefore investors usually buy shares at multiples of ROE.

• Gestation Period: ROE may be affected by the gestation period. A company may borrow money today to invest in long term facilities. The returns may take some time to start. This will show a low ROE but may be a positive sign. For this reason, ROE may not be an accurate measure.