What Is ROE vs. ROI (How They Differ and Examples)

Updated September 30, 2022

Measuring the profits on investments for companies can be a large part of a financial professional's job. Comparing ROE vs. ROI can provide useful insights and knowledge about the health of an investment and the trajectory of the company. Learning more about these measures can help you assess a company's financial health and make predictions about investments more effectively. In this article, we define ROE and ROI, examine the differences between the two metrics, review the drawbacks of each, and provide some examples of calculating both ROI and ROE.

Defining ROE vs. ROI

Here are some definitions to help you learn the difference between ROE vs. ROI:

What is ROE?

ROE stands for return on equity. Equity is the value of any shares that the company holds. This investment tool examines how well a company uses their money and assets to create profit. Financial professionals use ROE to help a company determine if they can grow their profits with their current investments. A higher value for ROE is a powerful indicator of the strength of the company and their financial future.

Whether ROE is good or bad depends on other ratios in the same field. Having a percentage that's higher than your competitors shows healthy growth within the field and is likely to indicate that the company is becoming more dominant. If the ROE is too high, such as if it doubles or triples that of competitors, can be an indicator that the company has a false calculation because of inconsistent profits or excessive debt.

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What is ROI?

ROI is an acronym for return on investments. This helps professionals determine the success and profitability of their investments. It also helps businesses examine the probability of the success and profitability of investments for stakeholders and investors. ROI doesn't consider any risks factors, so it's best to use it with a proper risk assessment. ROI is great for making direct comparisons with similar investments and can assist when ranking investments in different groups. These investments can expand beyond the stock market and can be used to assess the profitability of expanding a business or investing in real estate.

Related: What Is ROI? Understanding the Meaning and Calculation

Differences between return on investment and return on equity

Here's a list of some differences between the two terms:

Formulas for ROI and ROE

ROE and ROI use different formulas to perform calculations. Each formula requires different financial data, which helps differentiate the two equations. You can calculate ROE by dividing net income by stakeholders' equity. Here's the formula you can use:

Return on equity = net income / shareholder's equity

Comparatively, you can calculate ROI by taking net income and dividing it by the cost of investments. The formula for ROI is:

Return on investment = net income / cost of investment

ROI makes predictions while ROE indicates effectiveness

ROI can help determine the long-term financial success of investments by studying trends and making predictions about future profits. This measure uses investment strategies and trends to help discover if a particular investment may remain profitable. ROI uses the data from previous investments to help a company maintain investment growth. This is essential to having long-term success in investments and as a company.

As ROE examines equity and how much value each stakeholder has, it also assesses how well a company is being managed. This is because ROE takes into account all financial decisions, whether they were profitable, to develop an idea of the business's financial health. Managers and higher-level executives make most of those decisions in the company. If a company's equity and ROE start to trend downward, it can be a direct correlation to how well people have managed the company's assets. If their management is effective at managing their finances, the company may have a higher ROE.

Drawbacks of ROE

Here's a list of some drawbacks of using an ROE formula for your consideration:

Share buybacks can offset results

As ROE assesses stakeholder's equity, which can include company assets, the formula can be misleading when shareholders take part in share buybacks. A share buyback is when a company repurchases their own stock from the marketplace so they can give dividends to their shareholders. This is typically a sign of a company's faith in their stock and the belief that it may rise in value. This affects ROE because it reduces the outstanding stock in the market and decreases the liability of the stakeholder's equity.

Not all companies include intangible assets

Another factor that affects the reliability of ROE is when calculations include intangible assets. Intangible assets are items such as trademarks, copyrights, and patents that aren't considered monetary assets. A business can choose whether to include intangible assets in their calculations. This makes comparing ROE between businesses difficult because the numbers can be largely diverse depending on whether a company chooses to include the assets in the calculation.

Inconsistent profits disrupt ROE

One factor that can produce a false but high value for ROE is if the company has inconsistent profits. For example, if a company continues to not be profitable for a while and then suddenly has a profitable year, this can affect the ROE. This is because the continual losses of profit have devalued the shareholder's equity. When the sudden influx of profit happens, you're now taking a large net income and dividing it by a much smaller equity, producing an inflated ROE.

An inflated ROE can misconstrue the financial health of a business and may make it harder to determine when there's real financial growth.

Related: How to Become an Equity Researcher Analyst (Including FAQs)

Drawbacks of ROI

The following are some drawbacks of using the ROI formula:

Prioritizes short-term gain over long-term benefits

As ROI focuses on the profit of investments, it can encourage management to neglect the long-term benefits of certain investments for short-term gains. This may be because managers and stakeholders are looking to make a powerful impression at the end of a fiscal year or financial quarter. Making a short-term but profitable investment can help to increase the ROI and present a stronger performance for the company.

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Preoccupation with investment details

Investments are constantly in flux, depending on the market values and costs of acquiring new investments. Becoming hyper-focused on these factors and maintaining a strong ROI can prevent managers from making decisions that are best for the overall company's health. Becoming focused on individual factors can lead to missing out on more profitable long- and short-term investments.

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Example of ROE

The following is a situation where a company may want to evaluate ROE:

The company Wavelength Industries, manufacturers of emergency services radios, is coming to the end of their fiscal year. Their financial analysts are preparing a presentation for the stakeholders on what their share of the company is worth. The financial analyst determines that the company's net income last year was $325,000. They then calculated that the stakeholder's equity was at a value of $165,000. The formula to calculate this is net income divided by stakeholder's equity:

Return on equity = net income / shareholder's equity

$325,000 / $165,000

1.9 or 190%

The financial analyst presented these numbers to the stakeholders. They were very pleased with an ROE of 190%, which put them 15% higher than their closest competitors in the field.

Example of ROI

Below is an example of a situation where a company may want to know their ROI:

Wavelength Industries financial department is creating a report on the business's financial health and is examining their investment strategies for the previous year. Wavelength Industries had invested a total of $140,000 in the previous fiscal year. If they sold their current investments, they can make a net income of $200,000. The financial analyst can take the net income and divide it by the cost of investment. The formula to calculate this is net income divided by cost of investments:

Return on investment = net income / cost of investment

200,000 / 140,000

1.4 or 140%

These numbers show the analyst that the company did incredibly well with their investments in the past fiscal year. This figure can also demonstrate that there is potential for further financial growth with a similar investing strategy. Further risk assessments may take place, but the ROI is very favourable.

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