When investing, your capital is at risk and you may get back less than invested. Past performance doesn’t guarantee future results.
Return on Investment (ROI) vs Return on Equity (ROE) vs Return on Assets (ROA) vs Return on Capital (ROC)
Financial metrics can be confusing and, at times, daunting. That's why we've crafted an article that simplifies ROI, ROE, and ROA, offering you a straightforward path to boosting your financial acumen.
QUOTE
“Earnings are only a means to an end, and the means should not be mistaken for the end. Therefore, investors should pay more attention to where the earnings are coming from and where they are likely to go in the future.”
Big ideas
- In short, ROI measures overall investment efficiency, ROE gauges profit generation from equity, and ROA shows asset utilisation effectiveness.
- A high ROE might indicate strong performance or high debt, which means you must always think about the context for an accurate assessment.
- ROI's versatility extends across various investment types and provides a broad perspective of profitability.
- ROA's value varies by industry, highlighting the need for sector-specific benchmarks when evaluating performance.
What is Return on Equity (ROE)?
ROE can be thought of as putting a magnifying glass on how well a firm is using the money shareholders gave a company to generate earnings.
Another way to think of it is as a bit like a report card for a company's leadership team, showing how adept they are at reinvesting funds to grow the business.
Before the ROE definition, it's worth remembering what equity is.
Equity represents an owners' claim on the company's assets after all liabilities (what the company owes) have been deducted. In other words, equity is what remains for the shareholders once all debts and obligations are settled.
Another way to think of it is as a bit like a report card for a company's leadership team, showing how adept they are at reinvesting funds to grow the business.
Before the ROE definition, it's worth remembering what equity is.
Equity represents an owners' claim on the company's assets after all liabilities (what the company owes) have been deducted. In other words, equity is what remains for the shareholders once all debts and obligations are settled.
What is ROE?
Return on Equity (ROE) is a financial calculation that helps you understand how effectively a company is generating profits from its equity.
Calculating ROE: Return on Equity formula
ROE calculation
ROE = Net income / Shareholder equity
This equation gives you a percentage that indicates the rate at which the company is growing its equity.
This equation gives you a percentage that indicates the rate at which the company is growing its equity.
The Return on Total Equity formula broadens the perspective.
ROTE calculation
ROTE = Net income / Shareholder equity, including preferred shares
This equation gives you a percentage that indicates the rate at which the company is growing its equity.
This equation gives you a percentage that indicates the rate at which the company is growing its equity.
What does Return on Equity (ROE) tell you?
By comparing the net income of a business to its shareholder equity, ROE underscores how well a company is managing its resources to produce profit. It’s also a figure that is comparable among different companies within the same industry, offering an extra filter when deciding where to invest.
Note
A higher ROE can signal a company's superior efficiency at converting equity into profit.
A lower ROE could indicate less efficient use of shareholder equity to generate profit.
A lower ROE could indicate less efficient use of shareholder equity to generate profit.
However, it's crucial to look beyond the surface. An exceptionally high ROE could also result from high levels of debt, which poses its own risks.
Whether you're evaluating a firm within the FTSE 100 or considering a start-up in Milton Keynes, understanding ROE gives you a firmer ground on which to base your investment considerations.
Whether you're evaluating a firm within the FTSE 100 or considering a start-up in Milton Keynes, understanding ROE gives you a firmer ground on which to base your investment considerations.
Analysing Return on Equity (ROE)
Let’s look at two hypothetical examples of how to put ROE into perspective.
Comparing Return on Equity (ROE)
Imagine a UK-based retail company, RetailCo, which reports an impressive ROE of 18%, surpassing the broader market average for the FTSE 250, which stands at around 12%. At first glance, RetailCo appears to be an efficient generator of profit relative to its equity.
However, when compared to the retail industry's average ROE of 22%, RetailCo's figure isn’t so stellar, suggesting it is not performing as well as its peers in generating earnings from its equity. It’s important to compare ROE figures within similar industries because baseline norms can vary significantly.
However, when compared to the retail industry's average ROE of 22%, RetailCo's figure isn’t so stellar, suggesting it is not performing as well as its peers in generating earnings from its equity. It’s important to compare ROE figures within similar industries because baseline norms can vary significantly.
Considering debt structure, too
Now, consider a UK pharmaceutical company, PharmaGrowth, with an ROE of 25%. However, to assess this performance thoroughly, one would need to examine its debt structure. Assume that the average debt-to-equity ratio for the pharmaceutical industry is around 0.5, indicating a balanced use of debt and equity financing within the sector.
If PharmaGrowth exhibits a debt-to-equity ratio of 1.5, this would significantly exceed the industry norm, suggesting that the company is heavily reliant on debt financing. While this might not be inherently negative, it raises questions about the sustainability of its high ROE.
If PharmaGrowth exhibits a debt-to-equity ratio of 1.5, this would significantly exceed the industry norm, suggesting that the company is heavily reliant on debt financing. While this might not be inherently negative, it raises questions about the sustainability of its high ROE.
Negative shareholder equity, a situation where a company's liabilities exceed its assets, presents a unique analytical challenge. While it might suggest financial distress, context matters immensely. For some companies, particularly in sectors like leveraged finance, negative equity could be part of a strategic financial approach rather than a sign of impending failure.
Investors examining companies with negative equity should delve deeper into the reasons—the three biggest red flags might include:
Investors examining companies with negative equity should delve deeper into the reasons—the three biggest red flags might include:
- Accumulated losses
- Large dividend payouts
- Aggressive debt financing
Ratios in Trading 212 app
The information provided is for informational purposes only and should not be considered investment advice. Past performance is no guarantee of future results.
You can find the ROE, as well as ROI and ROA, under the ‘Management effectiveness’ tab under ‘All ratios’ on any stock in the Trading 212 app.
You can find the ROE, as well as ROI and ROA, under the ‘Management effectiveness’ tab under ‘All ratios’ on any stock in the Trading 212 app.
What is Return on Investment (ROI)?
Return on Investment (ROI) is a very versatile financial metric used to quantify the efficiency and profitability of pretty much any kind of investment.
What is ROI?
ROI calculates the percentage return on a particular investment relative to its cost, helping investors and businesses assess the performance of their various financial endeavours.
This metric offers a straightforward way to compare the financial benefits of different investments or actions, enabling a clearer decision-making process.
Return on Investment formula
ROI FORMULA
ROI = (Net Profit / Investment Cost) x 100
How do you interpret ROI calculations?
A high ROI indicates that the investment gains compare favourably to its cost, suggesting it was a wise decision.
A low ROI implies the investment did not generate significant financial returns.
However, it's crucial to consider the investment's timeframe and risk level, as these factors can influence ROI interpretation.
A low ROI implies the investment did not generate significant financial returns.
However, it's crucial to consider the investment's timeframe and risk level, as these factors can influence ROI interpretation.
What ROI is used for by investors
ROI can be used to assess your own investment decisions as well as part of your analysis of businesses in which you might invest, and the returns they are generating from their assets.
There are two main variations in which to use ROI.
Expected ROI: This involves using forecasted or estimated profits to determine the future return, serving as a predictive tool for potential investments.
For individual investors, expected ROI can guide choices on stocks, real estate, or education investments. By comparing the ROI of different investments, investors can decide where to best put their money. Of course, other factors must be considered, namely how risky the endeavour is compared to the possible return.
Realised ROI: This calculation uses actual historical data to measure how much return an investment has generated, providing a concrete assessment of its past performance.
Investors can use realised ROI to analyse the past performance of their investments by calculating the actual return they have earned relative to their initial outlay. This analysis helps them understand how effectively their money has been used and what their investment has yielded over a specific period.
There are two main variations in which to use ROI.
Expected ROI: This involves using forecasted or estimated profits to determine the future return, serving as a predictive tool for potential investments.
For individual investors, expected ROI can guide choices on stocks, real estate, or education investments. By comparing the ROI of different investments, investors can decide where to best put their money. Of course, other factors must be considered, namely how risky the endeavour is compared to the possible return.
Realised ROI: This calculation uses actual historical data to measure how much return an investment has generated, providing a concrete assessment of its past performance.
Investors can use realised ROI to analyse the past performance of their investments by calculating the actual return they have earned relative to their initial outlay. This analysis helps them understand how effectively their money has been used and what their investment has yielded over a specific period.
Examples of ROI calculations
Let’s imagine some hypothetical scenarios for investing in Tesla (TSLA) stock to illustrate both a winning and a losing investment:
EXAMPLES
Winning investment
Imagine you invested £50,000 in Tesla stock. Luckily, the value of your investment increased to £65,000. To calculate the ROI:
- Your net profit is £65,000 (final value) - £50,000 (initial investment) = £15,000.
- The ROI would be (£15,000 / £50,000) 100 = 30%.
This 30% ROI indicates a successful investment!
Losing investment
Conversely, suppose you invested £50,000 in Tesla stock, but this time, the value decreased to £40,000. To calculate the ROI:
- Your net loss is £40,000 (final value) - £50,000 (initial investment) = -£10,000.
- The ROI would be (-£10,000 / £50,000) 100 = -20%.
A -20% ROI signifies a losing investment, where you incurred a loss of 20% on the money you initially put in.
The information provided is for informational purposes only and should not be considered investment advice. Past performance is no guarantee of future results.
Imagine you invested £50,000 in Tesla stock. Luckily, the value of your investment increased to £65,000. To calculate the ROI:
- Your net profit is £65,000 (final value) - £50,000 (initial investment) = £15,000.
- The ROI would be (£15,000 / £50,000) 100 = 30%.
This 30% ROI indicates a successful investment!
Losing investment
Conversely, suppose you invested £50,000 in Tesla stock, but this time, the value decreased to £40,000. To calculate the ROI:
- Your net loss is £40,000 (final value) - £50,000 (initial investment) = -£10,000.
- The ROI would be (-£10,000 / £50,000) 100 = -20%.
A -20% ROI signifies a losing investment, where you incurred a loss of 20% on the money you initially put in.
The information provided is for informational purposes only and should not be considered investment advice. Past performance is no guarantee of future results.
What are the benefits of ROI?
The key benefit of ROI is its simplicity and universality because it can be easily compared and understood. It’s one number representing the financial success of an investment, which reduces the complexity involved in assessing various investment opportunities.
What are the limitations of ROI?
Despite its utility, ROI is a bit simplistic. It does not account for the time value of money, can vary significantly depending on how costs and returns are defined, and does not inherently factor in risk. Additionally, ROI cannot provide insight into the qualitative aspects of an investment, such as brand impact or customer satisfaction.
What are the alternatives to ROI?
Several alternatives offer more nuanced financial analysis, such as:
- Net Present Value (NPV)
- Internal Rate of Return (IRR)
- Return on Equity (ROE)
Each provides different perspectives and incorporates additional variables, like the time value of money or capital structure.
What is Return on Assets (ROA)?
DEFINITION
Return on Assets (ROA) is a financial ratio that illustrates how effectively a company is using its assets to generate profit.
It is a key indicator of managerial efficiency, offering insights into how well a company's management is converting its investments in assets into earnings.
How to calculate Return on Assets (ROA) with examples
ROA FORMULA & EXAMPLE
ROA = (Company's annual earnings / Total assets) x 100
Consider a company with £5 million in net income and £50 million in average total assets. The ROA would be calculated as (£5 million / £50 million) * 100 = 10%. This figure suggests that the company generates a 10p return for every £1 of assets it owns.
Consider a company with £5 million in net income and £50 million in average total assets. The ROA would be calculated as (£5 million / £50 million) * 100 = 10%. This figure suggests that the company generates a 10p return for every £1 of assets it owns.
What does ROA tell you as an investor?
ROA provides investors and analysts a quick snapshot through which they can assess a company's profitability relative to its total assets. It indicates how capable a company is of leveraging its assets to produce profit.
Investors use ROA to gauge a company's asset utilisation efficiency compared to its competitors and industry benchmarks. It helps identify companies that are generating adequate income relative to their asset base, i.e. Are they an asset-heavy vs. asset-light investment?
Investors use ROA to gauge a company's asset utilisation efficiency compared to its competitors and industry benchmarks. It helps identify companies that are generating adequate income relative to their asset base, i.e. Are they an asset-heavy vs. asset-light investment?
Limitations of ROA
ROA can be influenced by factors like asset depreciation or sector-specific asset intensity, which might skew comparisons across different industries. Also, it does not account for the company's debt levels.
Return on Assets (ROA) vs Return on Equity (ROE)
ROA measures efficiency in using assets to generate earnings, whereas ROE indicates how well the company uses shareholder equity to earn returns. That beggars the question, what is the difference between equity and assets?
Hopefully, you remember our definition of equity from above. Assets refer to everything a company owns that has economic value, such as cash, inventory, property, and equipment. These are resources expected to provide future benefits to the business.
You can summarise this by saying assets are what a company uses to operate and generate revenue, while equity signifies the residual interest in those assets that belong to the owners or shareholders.
Hopefully, you remember our definition of equity from above. Assets refer to everything a company owns that has economic value, such as cash, inventory, property, and equipment. These are resources expected to provide future benefits to the business.
You can summarise this by saying assets are what a company uses to operate and generate revenue, while equity signifies the residual interest in those assets that belong to the owners or shareholders.
Return on Capital (ROC)
Return on Capital (ROC) is a profitability ratio that helps investors understand how effectively a company uses its capital (both debt and equity) to generate profits.
Unlike the metrics that focus solely on equity or assets, ROC considers the total capital provided by both shareholders and creditors, offering a more '360-degree view' of a company's operational efficiency and profitability. It provides insights into how well a company is deploying its capital to create value, taking into account the returns generated from both equity and debt financing.
Unlike the metrics that focus solely on equity or assets, ROC considers the total capital provided by both shareholders and creditors, offering a more '360-degree view' of a company's operational efficiency and profitability. It provides insights into how well a company is deploying its capital to create value, taking into account the returns generated from both equity and debt financing.
Calculating ROC: Return on Capital formula
The formula for Return on Capital typically involves dividing a company's earnings before interest and taxes (EBIT) by the total capital employed (sum of debt and equity). This can be represented as:
FORMULA
ROC = EBIT (Earnings before tax and interest) / Total capital employed
The connection between ROI and ROE
While Return on Investment (ROI) and Return on Equity (ROE) are both metrics for assessing managerial performance, as reflected in the company’s returns. ROI measures the percentage return on a particular investment, whereas ROE specifically evaluates the profitability relative to shareholders' equity.
The connection between these metrics lies in their common objective to gauge efficiency and profitability, with ROI offering a broader investment perspective, while ROE provides an equity-focused viewpoint.
The connection between these metrics lies in their common objective to gauge efficiency and profitability, with ROI offering a broader investment perspective, while ROE provides an equity-focused viewpoint.
Recap
Return on Equity (ROE) and Return on Assets (ROA) are fundamental metrics for evaluating a company's financial and managerial efficiency, focusing on profitability from shareholder equity and asset utilisation, respectively. Return on Investment (ROI) offers a broader perspective on the profitability of various investments. Meanwhile, Return on Capital (ROC) provides insight into how well a company uses its total capital to generate profits.
Each of these metrics is useful on its own right to understand different aspects of a company's (or investment's) financial health and operational efficiency, essential for informed financial analysis and decision-making.
Each of these metrics is useful on its own right to understand different aspects of a company's (or investment's) financial health and operational efficiency, essential for informed financial analysis and decision-making.
FAQ
Q: ROA vs ROE: What's the difference?
ROA measures a company's earnings from its assets, focusing on operational efficiency, while ROE indicates how well a company uses shareholder equity to generate profits, reflecting financial leverage and equity management.
Q: Which should I use: ROI or ROA?
Use ROI to assess the broad profitability of any investment, gauging net gains relative to costs, and ROA to analyse how efficiently a company generates earnings from its assets, particularly useful for operational performance evaluation.
Q: What's the distinction between ROC and ROI?
ROC provides a comprehensive view of how well a company generates profits from all its capital, including debt and equity, whereas ROI focuses on the returns from specific investments applicable across various financial scenarios.
