Return on equity
The term "Return on equity" (abbr. ROE) describes how many percentage points profit were obtained from the equity, considering the last financial year. This key figure is often used to evaluate a company. It should be noted, however, that the ROE - depending on the sector of the company - can lead to enormous deviations and can be diluted by other factors.
Importance of the ROE
The return on equity has become more and more popular. The major American investor and inventor of the so-called value investment puts a high value on the ROE in his analyzes. In his opinion, a good ROE should be the basis for a very successful investment in equities or companies.
Calculation of the ROE
The return on equity can be calculated on the basis of the company's net income by dividing it by the capital employed.
Example:If a company has more than 100 million euros and has an annual profit of 5 million euros, the ROE is 5 percent. In the business world, 10 to 15% ROE is seen as a sign of a healthy and efficient business. However, the valuation should be diversified and compared with other key figures.
If a high ROE is available, this is considered a positive sign for the efficiency and profitability of a company. However, one has to keep in mind that there are industry-specific differences that can affect the ROE. Anyone who has a very high capital investment, but employs many people - thus has to bear high personnel costs - and at the same time only achieved a low profit margin, will sometimes have a low ROE, although the company was very successful.
However, if it is a company that has a very low cost structure and low equity, a significantly higher return can be achieved, making the company better on paper than it really is.
How to discover an efficient company
Even if there are sector-specific differences, it must be kept in mind that the ROE should be at least as high as the interest rate currently available on the capital market. However, if the return falls below the interest rate, the money could well be invested in the capital market.
The Leverage Effect
Another point that sometimes distorts the calculation is the so-called leverage effect. Since the ROE is only calculated on the basis of the equity used, additional borrowed capital can improve the indicator. Thanks to the debt capital an increase in profits is possible - the equity, however, remains constant. So the leverage effect ensures an increase in the ROE.
Remark the "silent reserves"
Today, the return on equity is one of the most important economic indicators if the profitability of the company is to be calculated or measured. Similar to the leverage effect, "silent reserves" can also distort the overall picture. The entrepreneur only uses his hidden reserves - there are rarely any increases in profit, since only their own reserves were used.