What is ROE index? How to calculate and apply ROE index effectively

The ROE index is commonly used in financial analysis, helping to measure the profit performance a business generates from its equity. So what is ROE? What is the meaning and application of this index in businesses? Let's find out more details with 1C Vietnam in the content below.

1. What is ROE index?

ROE (Return on Equity) is return on equity or return on capital. This is an important index in financial analysis used to evaluate a business's ability to use equity capital effectively to generate profits.

ROE shows the profitability and efficiency of a business in using equity capital. This index not only shows the attractiveness of a business to investors but also reflects the company's financial situation and health on the stock market.

2. What is the meaning of ROE index?

The ROE index has many important meanings in the financial activities of a business including:

• Evaluate financial performance: ROE indicates a business's ability to generate profits from equity. If the RO E index is high, this often shows that the business is using equity capital effectively to generate profits.
• Comparison with industry and competitors: ROE allows a business to compare its financial performance with companies in the same industry or competitors. From there, management can determine whether the business is outperforming or underperforming the market.
• Shows financial strength: A high ROE can show the financial strength of a business and its ability to attract investment from shareholders or funding from banks at lower interest rates.
• Evaluate growth: ROE analysis can also help evaluate a business's growth potential. If ROE increases over time, this may indicate that the business is managing equity more effectively and generating sustainable profits.

3. Exact formula to calculate Return On Equity index

Businesses can calculate ROE based on the following formula:

ROE = Net Income / Average Shareholders' Equity

In there:

• Net income is profit after taxes before paying dividends to common shareholders and after paying interest on the company's loans. ROE can be easily calculated if net income and equity are both positive.
• Average shareholders' equity is the sum of equity at the beginning and end of the period for a period in which the company has net income. This data can be obtained from the company's balance sheet.

In addition, businesses can apply another method of calculating ROE based on the formula:

ROE = Sustainable Growth Rate (SGR) / Retention Ratio

In there:

• SGR is the sustainable growth rate that a company can maintain without having to raise equity or increase debt.
• Retention Ratio is the rate of profit retention in the company, calculated by the formula: 1 - ratio of dividends paid to shareholders.

4. How to apply the ROE index in practice

4.1. Calculate the growth rate of the business

The growth rate of a business depends largely on the company's profitability.

Growth rate (g) = ROE x Reinvestment rate

Each year, businesses will spend a portion of their profits to pay dividends to shareholders. The remaining profits will be reinvested in production and business activities.

Reinvestment rate (%) = (1 – Dividend payment rate)

The future growth rate of a business can be calculated by multiplying ROE by the reinvestment rate.

For example:

Companies A and B have the same ROE = 10%. Company A has an annual dividend payout ratio of 20%. Company B has a dividend payout ratio of 40%. Then:

• Growth rate of A = 10% x (1- 20%) = 8%
• Growth rate of B = 10% x (1- 40%) = 6%

Although company A has a lower dividend payout than company B, company A is expected to have a higher growth rate in the future. In the long term, company A's stock will be more attractive than company B's stock.

4.2. Evaluate the ability to create value for shareholders

Capital efficiency plays an important role in determining the value shareholders receive. Normally, to evaluate the ability to create value for shareholders, the ROE index is compared with the expected rate of return when purchasing shares of the company (ie the cost of equity capital). This can be interpreted in the following cases:

• ROE index is less than the cost of equity capital: This is a sign that the business is operating inefficiently and is increasingly lower than initial expectations.
• ROE index is greater than the cost of equity capital: This shows that the company is operating well, knows how to reinvest earnings and create value beyond initial expectations.

4.3. Assess the competitiveness of the business in the future

Businesses with competitive advantages in brand, technology and other factors always demonstrate superiority over competitors. Thanks to that, businesses are able to achieve high profits and the ROE index is also superior to the industry average. This also demonstrates the sustainable competitiveness of the business in the market.

5. Limitations of the Return On Equity index

5.1. ROE index is unstable when profits are abnormal

Uneven changes in a company's profits are one of the causes of instability in the ROE index . This especially makes it difficult for management to evaluate performance and make decisions.

5.2. Governed by accounting policy

Some businesses can adjust accounting policies such as extending project life or reducing depreciation rates, to increase competition or attract investment capital. This has an impact on the net profit and ROE index of the business.

In addition, the ROE calculation formula does not include intangible assets such as patents, intellectual property rights, etc. This leads to errors in the calculation and does not fully reflect the advantages of each company. .

5.3. ROE index is affected when businesses buy treasury shares

ROE index can be affected and distorted due to stock acquisition. This happens when companies buy back their shares in the market to reduce their equity. When profit after tax remains unchanged and equity decreases, ROE will increase.

This artificial ROE index does not evaluate the actual capabilities of the business. Therefore, besides ROE, management also needs to pay attention to other indicators to ensure objectivity about the financial situation of the business.

In short, the ROE index is very important to evaluate a company's profit performance and investment capital utilization. Mastering how to calculate and apply ROE effectively will help you have a comprehensive view of the financial situation and profitability of your business. Don't forget to follow the articles on 1C Vietnam's website to update other useful information!