Return on Equity (ROE) is one of the financial ratios that is often used by investors to analyze stocks. This ratio shows the level of effectiveness of the company's management team in generating profits from the funds invested by shareholders. The higher the ROE, the greater the profit generated from the amount of funds invested so that it reflects the level of financial health of the company.
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Part 1 of 3: Calculating Return on Equity
Step 1. Calculate shareholder equity (SE)
Shareholders' equity is obtained from the difference between total assets (total assets or TA) and total liabilities (total liabilities or TL). Thus, SE = TA – TL. This information can be obtained from the annual or quarterly financial statements on the company website.
For example, a company has total assets of CU750,000,000 and total liabilities of CU500,000,000. Thus, the shareholders' equity is Rp750,000,000 – Rp500,000,000 = Rp250,000,000. This figure is needed to calculate the average shareholder equity
Step 2. Calculate the average shareholders equity (SEavg)
Calculate and add shareholder equity at the beginning of the period (SE1) and the end of the period (SE2) of the company and then divide by 2 to find SEavg. Thus, investors can measure changes in the company's profitability in one period or year.
- For example, calculate shareholder equity on December 31, 2015 by subtracting total assets and total liabilities. Do the same for shareholders' equity as of December 31, 2014, then divide both by 2. For example, Rp750,000,000 (assets) – Rp250,000,000 (liabilities) = Rp500,000,000 for December 31, 2014 and Rp1,250,000,000 (assets) – Rp500,000,000 (liabilities) = Rp750,000,000 for December 31, 2015. The company's SEavg is (Rp500,000,000 + Rp750,000,000)/2 = Rp625,000,000. This figure is needed to calculate ROE.
- You can choose the start date of the year period at any time, and then compare it to the same date in the previous year.
Step 3. Find the net profit (net profit or NP)
The company's net income is listed in the financial statements, precisely in the income statement. Net income shows the difference between income and expenses. If the company is making a loss (expenses are greater than revenue), use a negative number.
Step 4. Calculate Return on Equity (ROE)
Divide net income by average shareholder equity. ROE = NP/SEavg.
- For example, divide net income of $1,000,000 by average shareholder equity of $625,000,000 = 1.6 or 160% ROE. That is, the company generates 160% profit on every rupiah invested by shareholders.
- The company is quite profitable if its ROE is at least 15%
- Avoid investing in companies that have an ROE of less than 5%.
Part 2 of 3: Using ROE Information
Step 1. Compare the company's ROE over the last 5-10 years
This will provide information on the company's growth, but does not guarantee that the company will continue to grow at that pace.
- You may see increases and decreases during the period due to increased debt from loans. Companies cannot increase ROE without borrowing funds or selling shares. Debt payments will reduce net income. The sale of shares reduces earnings per share.
- Properties with high growth rates tend to have high ROE because they are able to generate additional income without the need for external funding.
- Compare ROE figures from companies of the same size and industry. Perhaps, the ROE is low because the industry you are in has a low profit margin.
Step 2. Consider investing in a company with a low ROE (below 15%)
Maybe the company is taking a major policy, for example the layoff of some of its employees, which results in negative company income figures and low ROE. Thus, the measurement of a company's profitability can be wrong if it only looks at the ROE and the level of profit/loss. Evaluate other profitability measures for companies with low ROE, such as the level of free cash flow before removing the company from the investment list.
For example, company ABC's net income declines due to increased expenses due to layoffs, purchases of new equipment, or office relocations. The company doesn't mean it won't make a profit in the future because big company policies usually happen only occasionally
Step 3. Compare ROE with Return on Assets (ROA)
ROA is the level of the company's ability to generate profits from each rupiah of assets it owns. These assets include cash in banks, company receivables, land and buildings, equipment, inventories, and furniture. ROA is calculated by dividing net income (obtained from the income statement) and the company's total assets (derived from the balance sheet). The smaller the ROA, the lower the company's profitability. Companies can have significantly different ROA and ROE numbers, due to company debt.
- Assets = liabilities + equity. Thus, companies that do not have debt have the same number of assets and equity. Therefore, the company's ROA and ROE figures are the same.
- However, if the company borrows funds and goes into debt, the company's assets increase (due to an increase in cash) and equity decreases (because equity = assets - liabilities).
- When equity decreases, ROE increases.
- When assets increase, ROA decreases.
Part 3 of 3: Evaluating the Health Level of the Company
Step 1. Investigate the amount owed by the company
If the company has a lot of debt, on paper the company's ROE will be high. This is because debt reduces the company's equity and increases its ROE. However, the number of assets also increased due to cash receipts from debt. Therefore, ROA will be lower because net income is divided by total assets.
Step 2. Calculate the price to profit ratio (Price Earnings Ratio or P/E ratio)
This ratio shows the company's current stock price compared to its earnings per share. The formula is, divide the Market Price per Share (current market price of the stock) by Earnings per Share.
- For example, the current market price per share of the company is IDR 25,000/earnings per share of IDR 5,000 = P/E ratio of 5.
- A high P/E ratio indicates that investors expect high profit growth in the future. A low P/E ratio indicates that the company is not attractive to investors or is doing better than past trends. The average P/E ratio since the 19th century has been around 16. 6.
Step 3. Compare the company's Earnings per Share
The company should show continued growth in revenue from sales over the last 5-10 years. Profit (earnings) is the amount of income earned by the company after paying all its expenses.
