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What is Return on Equity (ROE)?
Return on equity is a financial metric expressed as a percentage that helps measure how profitable a company is compared to the equity of its shareholders.
Key Takeaways
- ROE can help indicate how a company is managing its assets to generate profit.
- Shareholders’ equity and net income are the two factors used to determine ROE.
- ROE can be compared across companies within the same industry.
- Accounting standards and practices can impact the calculation of ROE.
- Don’t try to value a company based on ROE alone; instead, use the metric with other financial ratios when making an investment decision.
How ROE Works
The two factors used in the return on equity ratio are:
After a company’s ROE is calculated, you will be left with the percentage of earnings generated from its equity. Then, you can compare the ROE to other companies within the same industry to determine whether it’s managing equity in a profitable way when juxtaposed to its competitors.
Calculating Return on Equity
The return on equity formula is as follows:
The DuPont Formula
You can break down ROE into several components to further understand a company’s financial performance using the DuPont Formula.
The DuPont Formula is as follows:
ROE= Net Profit Margin x Asset Turnover x Equity Multiplier
WHERE
- Asset Turnover = Revenue / Total Assets
- Equity Multiplier = Total Assets / Shareholders’ Equity
By using these additional factors, the DuPont Formula is a more detailed calculation for ROE. This can help you better understand specific variables and how they impact a company’s profitability and return on investment (ROI).
Return on Equity vs. Return on Invested Capital & Return on Assets
| Return on Equity (ROE) | Return on Invested Capital (ROIC) | Return on Assets (ROA) | |
| Definition | Measures company profitability compared to shareholders’ equity | Measures company profitability compared to invested capital | Measures company profitability compared to total assets |
| Useful for | Comparing companies within the same industry | Determining efficiency across industries | Comparing industries with large assets |
| Pros | Easy to calculate and widely used by investors | Helps determine capital efficiency, accounting for both debt and equity | Helps measure the efficiency of asset usage |
| Cons | Does not account for debt | Complex to calculate | Can be misleading based on asset valuations |
How to Use Return on Equity
As an investor, you may be wondering, “Why is ROE important?” For one, you can use ROE to compare the profitability of two competing companies, here’s how.
Imagine you calculate the ROE of a company as 30%. Meanwhile, the ROE for a competing company in the same industry is 35%. This means the competitor is 5% more efficient when it comes to generating profit from its shareholders’ equity and, all other things being equal, may be a more financially sound company.
Keep in mind that ROE is only one financial metric, and shouldn’t be used in isolation to make investment decisions.
ROE Example
Say a company has $10 million in net income and shareholders’ equity of $50 million. Its ROE could be calculated as follows:
ROE = [$10 million / $50 million] x 100
ROE = 20%
An ROE of 20% means that for every dollar of equity in the company, $0.20 of profit is generated.
Using Return on Equity to Identify Risks
ROE can be a useful tool to help identify certain business risks, such as:
ROE Pros and Cons
- Can help determine a company’s efficiency, profitability, and potential stock performance
- Useful for comparing companies within the same industry
- An easy formula to calculate
- Share repurchases can skew ROE higher and make a company look more favorable
- Can be artificially inflated from high levels of corporate debt
- Must be looked at with other financial metrics to make an informed investment decision
The Bottom Line
Based on the ROE definition, this financial metric can be an indicator of how efficient a company is at leveraging its equity to generate profits. You can get a company’s ROE from their financial statements or use a return on equity calculator to help with the formula.
Keep in mind that ROE can be skewed by high debt or share repurchases, and you, therefore, should use ROE in conjunction with other financial metrics before making investment decisions.
At the end of the day, ROE is one of many important financial metrics that can be helpful for investors.
