Net income of a company divided by the value of its equity
In short:
Return on equity (ROE) is the return a company is generating per dollar invested by its equity investors, expressed as a percentage (ex. 15%). Simply put, ROE is a financial performance measurement that describes a company’s ability to produce a profit with respect to shareholder’s equity.
ROE is straightforward to calculate and is done by dividing net income by shareholder’s equity. On its own, ROE is not very insightful, therefore it is typical to compare the present performance of the company to its past and/or to other similar companies.
Formula:
Key Points
- Return on equity (ROE) measures the ability of a company to produce a profit on its shareholder’s equity.
- ROE is not insightful on its own and is typically compared against the past performance of the company and/or other similar companies.
- To calculate ROE, divide net income by shareholder’s equity.
In-depth:
Understanding ROE and How to Calculate
If you’re an equity investor it makes sense that you would want to know what type of returns on equity capital a company is capable of producing. But how exactly can an equity investor get an idea of the returns a company is producing on equity?
One quick accounting approach is to calculate the return on equity (ROE) which is done by dividing the net income of the business by the percentage of capital investors have in the business called shareholder’s equity. Shareholder’s equity is the total assets of the business minus the total liabilities.
If all goes right, calculating ROE will leave us with a percentage return on the equity of the company. We can then take this value and compare it to the past ROE’s of the company to see if it is increasing, decreasing, or staying the same. Additionally, we would want to compare the ROE we calculated for the company we’re looking at to other similar companies to see if it is more or less efficient with its equity.
Shortcomings of ROE
Unfortunately, like with any simple calculation in finance, it is open to weaknesses. Since we use the book value of equity (total assets – total liabilities) it can be skewed or manipulated to make the metric look better than it really is.
A few ways to do this would be if the company did an asset write-down, which is where they come in later and basically say “oh these assets aren’t quite worth what we thought or said they were”. An asset write-down would reduce the value in the denominator in our ROE equation and as a result increase the appearance of ROE. The other way a company may influence ROE is to repurchase shares, this would use cash from the assets side of the balance sheet and result in a lower asset value and in turn a lower shareholder’s equity value and higher ROE figure.
It should be noted that asset write-downs are not always for malicious intent neither are share repurchases. Actually, share repurchases are another form of a dividend to investors so they are typically a good thing. The point is, the analysis should go further than just one metric.
DuPont Analysis
To get a more in-depth look at what is actually driving ROE we break it into three parts the net profit margin, the asset turnover, and the amount of leverage a company is using. The DuPont Corporation is credited with originally creating this more detailed version of the ROE calculation that enables us to have more insight. Below is the formula:
Formula:
This formula is only an expanded version of the formula for ROE we showed at the beginning of this article. If we simplify the right side of the equation we’ll arrive back at the original formula.
Impact of Leverage
Leverage = Total Assets / Common Equity
Almost every company uses leverage (debt). The advantage it provides is reducing the cost of capital for the company and increasing returns on equity. However, leverage is not free, it adds risk to the company and too much leverage puts the company in a position to be susceptible to default if any difficult times arrive (which they will).
It’s important to know how much leverage a company is using when looking at ROE because it will heavily influence the returns on equity. By looking at the leverage amount a company is using we can compare their leverage amount to the industry average to see if they are potentially overleveraged.
To see the impact of leverage on ROE we have included an infographic below.
Impact of Net Profit Margin
Net Profit Margin = Net Income / Revenue
Breaking out the net profit margin of a company allows us to see how effective a company is at converting the revenue it’s generating into net income. Really small net profit margins mean that a company is incurring a lot of expenses in generating its net income.
The value of breaking out net profit margin from the ROE equation is that it gives us an important reference point to check against the past performance of the company and against the industry average. If we see that the company has been expanding its net profit margin this could mean that the company is becoming more efficient and will likely be able to increase its ROE in the future as well.
Impact of Asset Turnover
Asset Turnover = Sales / Total Assets
Asset turnover indicates the efficiency with which a company is using its assets to generate revenue. Typically a higher asset turnover ratio indicates that a company is getting more dollars out of its assets and therefore is operating more efficiently. That said, this ratio being “good” or “bad” is very dependent on the industry the company operates in and should be looked at against the average of that industry.
Ideally, a company will have a high asset turnover and high net profit margin indicating the company is generating large margins on large volume. However, it is more typical that a company with a lower asset turnover will have a higher net profit margin and vice-versa.
Frequently Asked Questions
Typically, a good return on equity (ROE) is somewhere between 14 – 20% generally speaking, and at least above 9-10%. However, a more precise “good ROE” will be industry-specific.
Return on equity indicates to common stock investors how well a company is doing at generating a profit on the shareholder’s equity in the business. This is important as it is one measure of the profitability of a company. Typically it is most useful and insightful when compared against the company’s past performance and other like-type companies.
To calculate return on equity divide net income by shareholder’s equity where shareholder’s equity is total assets minus total debt. ROE = Net Income / Shareholder’s Equity