Return on Equity (ROE)

How to Calculate Return on Equity (ROE)

The return on equity, or “ROE”, is a metric that represents how profitable the company has been, taking into account the contributions of its shareholders.

The ROE metric answers the question, “How much net profit is the company producing for each dollar invested by equity shareholders?”

Therefore, the return on equity (ROE) measure conveys the percentage of investor capital converted into net income on a dollar basis, which shows how efficiently the company handles the equity capital provided to them.

The process of calculating the return on equity (ROE) is relatively straightforward, as it divides net income by the average shareholders’ equity balance in the prior and current period.

Return on Equity Formula (ROE)

The formula to calculate the return on equity (ROE) is as follows.

Where:

• Net Income → Often referred to as “net earnings”, net income represents the post-tax profits of the company and can be found at the bottom of the income statement – hence, it is often called the “bottom line”.
• Shareholders’ Equity → One of the three major components of the balance sheet, shareholders’ equity is the other funding source besides liabilities (i.e. debt).

Hypothetically, if all the assets belonging to the company were liquidated and used to pay off all outstanding liabilities, the remaining value would represent the shareholder’s equity, as the equity claims are at the bottom of the pecking order.

While the shareholders’ equity balance can be found directly on the balance sheet, it can also be calculated by subtracting the company’s liabilities from its assets.

However, shareholders’ equity is a book value measure of equity, not the equity value (i.e. market capitalization). Since shareholders’ equity is equal to a company’s total assets, less its total liabilities, ROE is often called the “return on net assets”.

The average net income is used in the formula because the income statement tracks a period of time (e.g. quarter, fiscal year), while the balance sheet is the outstanding balance of different types of line items at a particular point in time (i.e. a “snapshot”).

What is a Good Return on Equity Ratio?

The return on equity (ROE) metric provides useful insights into how efficiently existing and new equity invested into the company is being utilized.

• High Return on Equity (ROE): The higher the ROE ratio, the more the company gains in net profits with the proceeds provided by equity investors.
• Low Return on Equity (ROE): The lower the ROE ratio, the less the company is earning in net profits with the proceeds contributed by equity investors.

Over time, if the ROE of a company is steadily increasing, that is likely a positive signal that management is creating more positive value for shareholders.

Note that the net income value should be taken prior to any issuance of dividends to common shareholders, as those payments impact the return to common equity shareholders. Meanwhile, the preferred dividends, which receive debt-like treatments, should be deducted from net income.

While a higher ROE is nearly always perceived positively, peer comparisons must be made between comparable companies in the same or similar industry, followed by in-depth analysis to identify the real drivers of the value.

Learn More → Return on Equity (ROE) by Sector (Source: Damodaran)

What is the Conceptual Meaning of Return on Equity (ROE)?

In particular, the return on equity (ROE) is an important metric to track for existing and prospective investors, as they would want to confirm how efficiently a company can use its money to create income post-investment – and how reliable management’s decision-making is.

Companies with a higher return on equity (ROE) are far more likely to be profitable from the proper allocation of capital, but also because of the ability to raise capital from outside investors if needed.

The optionality to raise capital is applicable to all companies and a trait that investors seek in potential investments (and the management team). It represents proof of a company’s ability to efficiently use capital and execute thoughtful strategic decisions.

Therefore, the fact that the company requires fewer funds to produce more output can lead to more favorable terms, especially in early-stage companies and start-ups.

When investors provide capital to companies, they also invest in the ability of management to spend their capital on profitable projects without wasting the capital or using it for their own benefit.

What are the Limitations of Return on Equity (ROE)?

The return on equity (ROE) cannot be used as a standalone metric, as it is prone to be affected by discretionary management decisions and one-time events.

• Stock Buyback: For example, share buybacks could cause the shareholders’ equity balance to decrease – and the lower denominator can cause an “artificial” increase in ROE.
• Dividend Issuance: The issuance of dividends to preferred shareholders also has a similar impact, as preferred dividends come straight out of retained earnings and reduce the earnings retention rate.
• One-Time Item: One-time, non-recurring events can also cause ROE to be misleading, such as a significant inventory write-down. The result would be a lower net income from the expense recognized on the income statement, but only in the year the write-down is formally charged. The net impact of the write-down can cause the shareholders’ equity balance to fall, which offsets the expense and creates the false illusion that there have been improvements in the company’s return to shareholders.

There are many reasons why a company’s ROE may beat the historical average or fall short of it. For that reason, investors often look at complementary metrics, such as ROIC, to help understand the full picture of the business.

What are the Full-Form Components of Return on Equity (ROE)?

The return on equity (ROE) formula – once broken down further into its full-form components – can be segmented into three distinct parts:

• Net Profit Margin = Net Income ÷ Sales
• Return on Assets (ROA) = Net Income ÷ Total Assets
• Financial Leverage = Total Assets ÷ Common Equity

One noteworthy consideration of the return on equity (ROE) metric is that the issuance of debt capital is not reflected since only equity is captured in the metric.

In effect, whether a company has excessive debt on its B/S, is opting to raise risky debt rather than equity, or generates more profits using funds from debt lenders is not reflected in the ROE metric.

Instead, one could easily misinterpret an increasing ROE, as the company produces more profits using less equity capital, without seeing the full picture (i.e. reliance on debt).

The more debt a company has raised, the less equity it has in proportion, which causes the ROE ratio to increase.

If there is an all-equity financed company, its ROE and ROA will be equal – i.e. the balance sheet equation states that “Assets = Liabilities + Shareholders’ Equity”.

But if the company raised debt for the first time, the net impact would be a positive increase to ROE (i.e. ROE > ROA) due to the increased cash balance, which causes the total assets side to rise.