What is return on equity?

What is return on equity?

Return on equity (ROE) shows how much profit a company generates per dollar of shareholders' equity. You calculate it by dividing net income by shareholders' equity. A 20% ROE means you earn $0.20 per dollar invested.

You use ROE to judge how well a company turns your money into profit. A 15% ROE beats bonds and savings accounts. ROEs of 15 to 20% are generally considered good.

But ROE alone can fool you. A company can boost ROE by taking on debt. That raises risk. You must compare ROE against peers with similar capital structure. ROE is leverage-sensitive, so a high number may just mean heavy borrowing.

How to calculate return on equity?

The formula is simple: net income divided by shareholders' equity. Use average equity over the year for accuracy. You find net income on the income statement. Equity sits on the balance sheet. Equity is assets minus liabilities, so ROE is really a return on net assets.

Why average equity? Because net income covers a full year, but equity changes daily. Add beginning equity to ending equity, then divide by two. That gives you a fairer picture. Analysts call this version return on average equity, or ROAE.

Net income means profit after all expenses and preferred dividends. Preferred shares get paid before common stock, so subtract those dividends first. What remains belongs to common shareholders, whose equity you are measuring. Equity breaks into common shares, preferred shares, contributed capital (additional paid-in capital), and retained earnings.

Example: Company A has net income of $10 million and shareholders' equity of $50 million. ROE is 20%. That means $0.20 profit per dollar of equity. Using average equity would refine this result slightly.

What is a good ROE?

A good ROE depends on your industry. Utilities carry heavy debt and assets, so 10% may be normal. Tech and retail firms often hit 18% or more. Compare ROE to companies in the same business.

A rule of thumb: look for ROE at or above the sector average. If a company holds 18% while peers sit at 15%, management is doing something right. But if ROE is double the industry average, dig deeper.

The DuPont formula breaks down ROE

The DuPont formula splits ROE into three parts: net profit margin times asset turnover times leverage. This shows you what drives ROE. Each part tells a different story. A change in any one part moves the final ROE number.

Net profit margin measures how much profit you keep from each sale. Asset turnover shows how efficiently you use assets to make sales. Leverage shows how much debt you use.

Higher leverage raises ROE through a simple mechanic. Interest is tax-deductible, while dividends to shareholders are not. So debt financing costs less after tax, which lifts ROE. But debt also magnifies losses and cuts both ways in a downturn. Compare ROE with peers that have similar debt levels.

Risks and limitations of ROE

Negative ROE means the company lost money or has negative shareholders' equity. You can't compare it against positive ROE stocks. A loss reduces equity, which can make ROE look artificially high later.

Share buybacks can inflate ROE. Buying back shares shrinks the equity base, so the same profit divides into a higher ratio. The company did not get more efficient. It just made the denominator smaller.

Inconsistent profits can inflate ROE. A company that lost money for years has a small equity base. One good year then produces a misleadingly high ROE. Check the history before trusting the number.

ROE also ignores how a company uses debt. ROIC, or return on invested capital, includes debt in the picture. ROIC shows returns before the leverage effect. Use both to get the full story.

ROE and stock valuation

Higher ROE doesn't always mean higher stock price. Many other factors matter. Growth expectations and market sentiment also move the price. Use ROE with other ratios like price-to-book and debt-to-equity.

ROE helps you estimate growth. Multiply ROE by the retention ratio to get the sustainable growth rate. A company that reinvests profits at high ROE can grow fast. But check if it's sustainable.

How is ROE different from ROA?

Return on assets, or ROA, divides net income by total assets instead of equity. Assets include debt and equity together. ROA shows how well the company uses everything it owns. ROE shows only the return on money owners put in.

ROE and ROA diverge on debt. More debt lifts ROE, but only when the return on assets of that debt exceeds its interest rate. Otherwise cost of debt and default risk push ROE down. Return on tangible equity (ROTE) strips out goodwill and intangibles, useful after a big acquisition.