What Is Return on Equity?
Return on Equity (ROE) is a financial measure of profitability which illustrates how effectively a company manages Shareholders’ Equity and gets profit from it. By using Return on Equity investors can see if they’re getting a good return on their investments, while a company can evaluate if they’re using company’s equity efficiently.
ROE ratio tells how much profit a company generates for every $1 of shareholders’ equity. For example, ROE of 10% means that a company generates $0.10 of profit for every $1 of shareholders’ equity.
How to Calculate Return on Equity?
Return on Equity is calculated by dividing a fiscal year’s Net Income by Total Shareholders’ Equity. This number should be multiplied by 100 to be expressed as a percentage.
ROE = \frac{Net\space Income}{Total\space Shareholders'\space Equity} \times 100Net Income is calculated after dividends are paid to preferred shareholders but before being paid to common shareholders.
ROE can also be delivered by dividing company’s dividend growth rate by its earnings retention ratio.
ROE = \frac{Dividend\space Growth\space Rate}{Earnings\space Retention\space Ratio}ERR = \frac{Net\space Income - Dividends}{Net\space Income} = 1 - \frac{Dividends}{Net\space Income}ERR = 1 - Payout RatioROE = \frac{Dividend\space Growth\space Rate}{1 - Payout\space Ratio}Dividend Growth Rate is the percentage growth rate of company’s dividend during a certain period of time. It’s calculated by dividing Dividends paid in year X by Dividends paid in year X-1 and subtracting 1 from this number.
Dividend\space Growth\space Rate = \frac{Dividends_{year X}}{Dividends _{year X - 1}} - 1Earning Retention Ratio (ERR) is a percentage of a company’s income that is kept back in the company to develop and strengthen the business rather than being paid to the shareholders in form of dividends.
Payout Ratio is conversely a percentage of company’s income that is paid to the shareholders in form of dividends. Therefore, Earnings Retention Ratio and Payout Ratio make up company’s Net Income.
As well as a lot of financial ratios, Return on Equity should be compared:
- In time for the same company. By comparing ROE in time, we can create a trend and look for positive or negative changes.
- With other companies in the same industry. It allows to compare company’s financial performance with competitors.
Although there’s no ideal ROE value, ROE below 10% is considered poor. Investors tend to consider ROE of 14% as acceptable and 15-20% as good. For example, ROE of 17% means that a company makes $0.17 of profit for every $1 of shareholders’ equity. A rising ROE means that a company is increasing its ability to generate profit without needing as much funds.
Using ROE to compare stocks can be helpful, but investors should be careful while comparing stocks that are very different. ROE is supposed to be used along with other financial ratios to get more complete and informative picture of company’s financial condition.
Example of Return on Equity Calculation
- Company’s Annual Net Income for the past fiscal year was $2,000,000
- Total Shareholders’ Equity was $ 10,000,000
Return on Equity for this company is calculated as:
ROE = \frac{\$2,000,000}{\$10,000,000} \times 100 = 20\%This means that this company generated $0.20 of profit for every $1 of shareholders’ equity, giving a ROE of 20%.
Return on Equity in DuPont Analysis
DuPont Analysis is a method of deconstructing ROE into three components – Equity Multiplier, Asset Turnover and Net Profit Margin. It allows to indicate how Asset Use Efficiency, Financial Leverage, Operating Efficiency affect company’s Return on Equity, determine sources of strengths and weaknesses and focus attention on drivers value. Return on Equity can be calculated by multiplying Profit Margin by Asset Turnover by Equity Multiplier.