Investors often want to know how successfully and efficiently a company’s managers are using their money. The stock price gives some strong clues, but a number of things drive the valuation of a company’s shares. One of the most important is return on equity.
What is return on equity?
Return on equity, or ROE, measures how effectively a company is using shareholders’ money to generate a profit.
Calculating return on equity is a bit more complicated than some other financial ratios because investors must turn to two sources to get the relevant information—the company’s income statement and its balance sheet, which accounts for total assets and total liabilities. When assets are greater than liabilities the difference is shareholders’ equity. ROE is calculated by dividing a company’s net income by shareholders’ equity.
Here’s the simple formula for ROE:
ROE = net income / shareholders’ equity
Two things account for increases in equity on a company’s balance sheet:
- Paid-in capital. This is money raised from the sale of shares through public offerings, either in an IPO or in a secondary offering, and added to shareholder equity on the balance sheet.
- Retained earnings. This is mainly how shareholder equity increases over time. Retained earnings is net income minus dividend payments. They flow from the income statement to the balance sheet.
Example of ROE
Let’s imagine Company A, which has $6 million in equity after selling 300,000 shares at $20 each in an initial public offering (IPO). Now, let’s say that in its first year as a public company it had sales of $10 million and net income of $2.5 million. After paying $1 million in dividends, the company has what’s called retained earnings of $1.5 million.
With the addition of the $1.5 million of retained earnings, shareholders’ equity will rise to $7.5 million. The calculation of ROE is:
$2.5 million/$7.5 million = 0.333 or 33.3%
Return on equity (ROE) formula and calculation
The simple formula for return on equity is net income divided by shareholders’ equity. A more detailed formula is often used to see what particular factors drive the return. It’s called the DuPont formula, or DuPont analysis, and it combines three ratios:
Net income Sales Assets
---------------- X --------- X --------- = Return on equity
Sales Assets Equity
This is the same as saying:
Profit margin X Asset Turnover X Leverage = Return on Equity
In the DuPont formula, multiplying the three ratios, sales and assets in numerator and denominator cancel each other out, bringing the result of DuPont analysis back to net income dividend by equity. (All numbers are in millions and asset value is introduced to illustrate.)
$2.5 net income $10 sales $12.5 assets
-------------------- X -------------- X ------------------
$10 sales $12.5 assets $7.5 equity
(profit margin) (asset turnover) (leverage)
0.25 (25%) X 0.8 (80%) X 1.667 (166.7%) = 0.333 (33.3%)
A quick analysis shows Company A’s profit margin is 25%, its asset turnover is 80%, and leverage is 166.7%.
Variations of ROE
Investors may also examine a variation of ROE called return on invested capital (ROIC), which includes all sources of capital such as debt from bond offerings and bank loans. While ROE uses only shareholders’ equity (assets minus liabilities) in the denominator, ROIC includes debt, because a company can also use borrowed money as capital to invest in assets. ROE gauges how well the company is using its shareholders’ equity capital; ROIC gauges a company’s effectiveness with all sources of capital.
Let’s assume that Company A above took out a $5 million bank loan, in addition to its $6 million IPO. Its total capital, including $7.5 million in shareholder equity ($6 million from the IPO plus $1.5 million in retained earnings) and $5 million in debt, is $12.5 million. So while Company A’s return on equity is 33.3%, its return on invested capital is 20%:
---------------- = 0.20 (20%)
Companies carrying debt will have a lower ROIC—which is the sum of shareholder equity and borrowed money—than ROE because the denominator is larger in the equation.
What does ROE tell you?
Return on equity tells investors if a company is making good use of their money to generate earnings, particularly when compared to its competitors and the rest of the industry. It also provides a good basis for estimating a company’s sustainable earnings growth rate and a fair value for the stock price.
A sustainable growth rate is determined by a company’s ROE and its ratio of retained earnings. Said another way, sustainable growth is the ROE a company could expect to achieve without taking on debt—using leverage—to finance growth.
So, per the Company A example, if it retains $1.5 million of the $2.5 million in net income, that’s a 60% retention ratio. Sustainable growth is then ROE times the retention rate or:
33.3% (0.333) X 60% (0.6) = 0.1998 or 19.98%
Reducing the dividend payout and increasing the earnings retention would boost the sustainable earnings growth rate.
What doesn’t ROE tell you?
Return on equity can fluctuate from quarter-to-quarter based on net income. A sudden jump in earnings, or an unexpected loss, can distort ROE. Also, investors must match income statement and balance sheet periods, and use at least a fiscal year or trailing four quarters, to capture a company’s full business cycle.
ROE can also be distorted by changes to the balance sheet such as debt-financed stock buybacks, or write downs of asset values. In other words, the ROE denominator can be altered by corporate actions.
ROE vs. ROA
Return on assets, or ROA, is another way of evaluating financial performance. In ROA, a company’s net income is divided by total assets. Because total assets are always larger than shareholder equity, the ROA figure will be smaller than ROE.
Comparing ROE against ROA may reveal whether a company has found an efficient balance of equity and debt, or if its debt burden has become too large and disproportionate in the ROE equation.
FAQs about ROE
What is a good return on equity?
A company’s ROE can be compared to its competitors and relative to an average for its industry. In general, an industry with fewer companies that generate strong sales and earn a lot with less in assets, tend to have higher ROEs. In contrast, an industry that is capital-intensive and requires more assets to drive growth will generally have a lower ROE. The average ROE of roughly 7,200 companies in the U.S. was about 18% at the end of 2021, according to an analysis by New York University’s Stern School of Business.
What happens when shareholder equity is negative?
A company can have negative ROE when losses wipe out shareholder equity, just in the opposite way that retained earnings increase equity. Or, the company may have negative equity when liabilities exceed assets. Either way, a company can’t be compared against its competitors based on ROE when this occurs.
What effect does leverage have on ROE?
Leverage, or borrowed money, can magnify return on equity because it reduces the ROE denominator (assets minus liabilities), relative to the numerator (net income). Investors must consider whether the amount of a company’s leverage is sensible, or if the debt burden is too large and the company risks a default on debt payments.
The bottom line
Return on equity is a key measure for investors to evaluate how effectively and profitably a company is using shareholders’ equity from accumulated earnings and stock offerings. It’s also used to estimate an appropriate share valuation based on a company’s balance between paying dividends and reinvesting earnings. Investors may find ROE most useful in evaluating comparable companies in the same industry, because different industries can have very different prevailing and historical returns on equity.