The “What Is…?” series helps to demystify investing terms for people who are just starting out in the stock market.
In this edition, let’s understand more about the term, “return on equity”.
So, What Is Return on Equity (ROE)?
ROE reveals how much a company earns with every dollar that shareholders have invested in it.
ROE also shows how efficient a firm’s management is in using shareholders’ capital.
When evaluating a company’s ROE, it’s important to compare it to companies of the same industry to determine if the company’s business is strong.
We can also compare a company’s most recent ROE to its ROE from previous years to see if there’s business growth.
A company with an above-average ROE in its industry could mean that it has a durable competitive advantage and that management is doing an excellent job.
Return on Equity Formula
ROE can be calculated by looking at the income statement and balance sheet of a company’s financial statements.
The formula to ROE is:
ROE = (Annual Net Income / Average Shareholders’ Equity) * 100%
The net income of a company is found in its income statement (also known as profit and loss statement) while the shareholders’ equity can be seen on the balance sheet.
We are using the average shareholders’ equity from two continuous years since the balance sheet represents a snapshot in time (eg. as of 31 December 2019) while the income statement takes into account a period of time (eg. 12 months from 1 January 2019 to 31 December 2019).
Calculating Return on Equity of a Listed Company
To illustrate the return on equity calculation, let’s take a look at Singapore’s largest telco, Singapore Telecommunications Limited (SGX: Z74).
Singtel posted S$3,094.5 million in net income for its 2019 financial year, and its average shareholder equity stood at S$29,787.5 million (using end-March 2018 and 2019 figures).
| FY2019 | As of 31 March 2019 | As of 31 March 2018 | |
|---|---|---|---|
| Net income (S$' million) | 3,094.5 | N/A | N/A |
| Shareholders' equity (S$' million) | N/A | 29,837.8 | 29,737.1 |
| Average shareholders' equity (S$' million) | N/A | 29787.5 | |
Using the ROE formula shown earlier:
Singtel’s 2019 ROE = (S$3,094.5 million/S$29,787.5 million) * 100% = 10.4%
We can compare Singtel’s latest ROE with those of previous years to analyse if the telco’s management is becoming more efficient in using shareholders’ money.
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Disclaimer: The information provided by Seedly serves as an educational piece and is not intended to be personalised investment advice. Readers should always do their own due diligence and consider their financial goals before investing in any stock.
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