Return on Equity (ROE)
Ratios
Overview
Return on Equity is a profitability ratio that measures the return that a company earns based on Shareholders' Equity. It is calculated by dividing Net Income (from the Income Statement) by Shareholders' Equity (from the Balance Sheet).
Knowing that Shareholder Equity is Assets minus Debt, we can think of ROE as return on net assets. The ROE is considered a measure of how efficient the company is at using its assets to create profit. ROE shows how well a company uses the investment funds to generate profitability and growth.
All things being equal, investors will generally prefer companies with higher return on equity. ROE is one of the most important financial ratios and it is commonly used as a measurement of quality of management as well as profitability of the investment for the investor.
Alternative Names: ROE, Return on Net Assets
Formula
Return on Equity = Net Income ÷ Average Shareholders' Equity
Components: Net Income is the amount of income, net of expenses and taxes, that a company generates for a given period and it can be found on the income statement. Average Shareholders' Equity is calculated by adding equity at the beginning of the period (in this case, the beginning of the year) and equity at the end of the period. The beginning and end of the period should match the period for which net income is earned. The Shareholders' Equity can be found on the balance sheet of the company's annual report.
Important Note: Return on equity is expressed as a percentage and can only be calculated for any company if net income and equity are both positive numbers.
Calculation Example
Let's calculate the return on equity for a hypothetical company to demonstrate the process:
Example Company - Financial Data:
- Net Income for the Year: $600,000
- Shareholders' Equity (Beginning of Year): $3,000,000
- Shareholders' Equity (End of Year): $4,000,000
Step 1: Calculate Average Shareholders' Equity
Average Shareholders' Equity = (Beginning Equity + Ending Equity) ÷ 2
Average Shareholders' Equity = ($3,000,000 + $4,000,000) ÷ 2
= $3,500,000
Step 2: Calculate Return on Equity
ROE = Net Income ÷ Average Shareholders' Equity
ROE = $600,000 ÷ $3,500,000
= 0.1714 or 17.14%
Interpretation: A return on equity of 17.14% means that for every $1 of shareholders' equity, the company generates $0.17 in net income. This indicates strong profitability and suggests management is effectively using shareholder investment to generate returns.
How to Interpret
All things being equal, investors will generally prefer companies with higher return on equity. The average ROE for US companies historically has been around 10% to 12%. For stable economies, companies with ROEs more than 12-15% are considered good.
General Guidelines:
Below 10%: Weak Profitability
Low ROE below the historical average of 10-12% indicates the company is struggling to generate adequate returns on shareholders' equity. This may signal operational challenges, competitive pressures, or inefficient use of shareholder capital. The company is not effectively converting equity investments into profits.
10% - 15%: Acceptable Performance
ROE in the 10-15% range represents acceptable performance, with values around 10-12% matching the historical average for US companies. The company is generating reasonable returns on shareholders' equity, comparable to industry standards, and demonstrates stable profitability and management effectiveness.
Above 15%: Strong Performance
ROE above 12-15% is considered good for companies in stable economies. High ROE indicates the company is highly efficient at using shareholders' equity to generate profit. This suggests superior operational efficiency, strong competitive positioning, and effective management that is successfully creating value for shareholders.
Important Context: The ROE ratio strongly depends on many factors such as industry, economic environment, company size, and growth stage. What's considered a good ROE varies significantly by sector. Always compare companies within the same industry and consider the broader economic conditions when evaluating performance. Industry-specific benchmarks are essential for proper interpretation.
Why It Matters
ROE is one of the most important financial ratios and it is commonly used as a measurement of quality of management as well as profitability of the investment for the investor. It provides essential insights into how effectively a company is using shareholder capital to generate profits.
Key Insights:
- Shareholder Value Creation: Measures the return that a company earns based on Shareholders' Equity, showing how well a company uses investment funds to generate profitability and growth. Investors will generally prefer companies with higher ROE as they are creating more value from shareholder capital.
- Return on Net Assets: Since Shareholder Equity equals Assets minus Debt, ROE can be thought of as return on net assets. This perspective shows how efficiently the company is using its net assets (after accounting for debt) to create profit.
- Asset Efficiency Measurement: ROE is considered a measure of how efficient the company is at using its assets to create profit. It reveals whether management is effectively deploying the resources available to them to generate returns for shareholders.
- Management Quality Indicator: Commonly used as a measurement of quality of management. High ROE suggests management is making effective decisions about capital allocation, operations, and strategic positioning. It reflects how well leadership is executing on the company's business model.
- Investment Profitability Assessment: Serves as a key measure of profitability of the investment for the investor. ROE directly shows how much profit is being generated per dollar of shareholder investment, making it one of the most relevant metrics for equity investors evaluating potential returns.
Key Takeaways
- Return on Equity is a profitability ratio measuring the return a company earns based on Shareholders' Equity
- Calculated by dividing Net Income (from Income Statement) by Shareholders' Equity (from Balance Sheet)
- Since Shareholder Equity = Assets − Debt, ROE can be thought of as return on net assets
- Measures how efficient the company is at using its assets to create profit
- Shows how well a company uses investment funds to generate profitability and growth
- Formula: Return on Equity = Net Income ÷ Average Shareholders' Equity (expressed as a percentage)
- Can only be calculated if net income and equity are both positive numbers
- Average ROE for US companies historically around 10-12%; ROEs above 12-15% considered good in stable economies
- Investors generally prefer companies with higher return on equity
- One of the most important financial ratios, commonly used to measure management quality and investment profitability
- Ratio strongly depends on industry, economic environment, company size, and growth stage
- Essential to compare companies within the same industry for accurate assessment
Related Financial Ratios
These related metrics provide additional insights for comprehensive financial analysis:
Return on Assets (ROA)
Measures profitability relative to total assets. While ROE focuses on returns to shareholders' equity, ROA measures returns on all assets including those funded by debt. ROA provides a broader view of asset efficiency, while ROE specifically shows shareholder returns.
Return on Sales (ROS)
Also known as net profit margin, measures how much net income is generated per dollar of sales revenue. While ROE shows profit efficiency relative to shareholders' equity, ROS shows profit efficiency relative to revenue. Both are profitability metrics but measure efficiency from different perspectives.
Return on Invested Capital (ROIC)
Evaluates returns generated from all invested capital (both debt and equity). ROIC provides a comprehensive view of how efficiently a company uses all sources of capital to generate returns, complementing ROE's focus on equity returns and showing overall capital efficiency.