The importance of return on equity and how to calculate it

There are many ways to think about company performance and profitability, with ROE being one of the commonly used metrics. It is primarily used by investors who want to invest in a company for the long term, as opposed to those looking for the next hot stock. This is mainly because this metric is updated on a quarterly basis when companies report earnings. Also, it's common to compare previous quarters, and even years, to determine a company's health.

To understand the essence of ROE, however, you first need to understand the “E.” 

Equity —also known as shareholders’ equity — is the amount of money company owners have invested in the business. It includes funds from shareholders (not just the people in the executive suite), as well as any amounts directly invested in the company and all the income the company has reinvested since its inception, minus debt. 

The point of the ROE ratio is to measure how much profit a company generates for each dollar of equity. 

ROE gives you a way to gauge a company’s profitability and, more specifically, the efficiency at which the company has been turning your investment into income and growth. It can also be a useful tool if you’re looking at two similar companies in the same sector. Comparing ROE among companies from different sectors — for example, a bakery and an auto parts manufacturer — may be less useful as each industry has its own capital requirements.

The ROE calculation is fairly straightforward. To calculate the ROE on your own, you’ll need the company’s net income (income less expenses and taxes) for the previous fiscal year or trailing 12 months. 

You will also need to track down the company’s average shareholders’ equity, which can be found on the company’s balance sheet. The average should be calculated over the same period of time as net income. To get the average, add the shareholders’ equity from the beginning of the period to that from the end of the period, and divide by two.  

Return on Equity   = Net Income / Average Shareholders’ Equity 

The resulting ROE ratio is expressed as a percentage. 

If a company reports an annual net income of $5.2 million and has an average shareholders’ equity of $40 million over that same fiscal year, its ROE is 13%. (5.2 / 40 = 0.13) 

Now, if that company consistently reports an ROE in that range, but others in its industry average 11.5%, you can infer that the company’s management team is more effective than average at using equity to generate profits.  

However, it’s difficult to compare across sectors. A different company in another sector may have a higher ROE of 15%, but if its industry average is 17%, then it’s actually underperforming. 

The ROE can be analyzed in two ways: 

These two factors provide important context for any individual company’s ROE. Averages may vary by sector, sometimes quite significantly. Generally, however, some investors might consider an ROE of 15% to 20% to be a positive sign, while 5% might be considered low.  

With the ROE, you can also calculate a company’s Sustainable Growth Rate (SGR) to measure the pace at which a company can grow using its own internal earnings. This can be an indicator of the life cycle stage a company is currently in, which can impact its competitive strategy, sources of financing, dividend payout policies and more. 

To find SGR, multiply a company’s ROE by its earnings retention rate, which is the proportion of earnings kept back in the business as retained earnings — the percentage of its profits reinvested in the company rather than paid out to investors as dividends. 

DuPont Equation is a variation of the standard ROE calculation. Some investors favour this approach because it can provide a clearer picture of the underlying causes over time of a company’s ROE. Also known as the strategic profit model, the DuPont Equation was created by the DuPont Corporation and implemented by its businesses in the 1920s. 

DuPont analysis breaks ROE down into three parts: profit margin, asset turnover and leverage. 

Return on Equity   = (Net income / sales) x (sales/total assets) x (average total assets/average shareholder's equity)

Another way to look at it: 

ROE = Profit Margin  x Asset Turnover  x  Financial Leverage 

Deconstructing the equation in this way allows an investor to isolate what’s driving changes in a company’s ROE. For example: 

While the DuPont equation is less useful in certain industries — investment banking, for instance — it can help you determine what is driving a company’s ROE: profitability, use of assets or debt. In retail, asset turnover matters most, while the profit margin is most significant to high-margin industries like fashion. In other sectors, like the financial sector, companies rely most on high leverage to produce ROE. 

Repurchasing shares from the market can skew ROE, because it reduces the number of outstanding shares, thereby lowering the average shareholders’ equity and boosting ROE. Buybacks impact ROE without an actual change in how the business operates. 

If a company reports negative income, the ROE will also be negative, but this isn’t always a bad thing. For example, start-ups often report losses for years prior to turning a profit. Also, a company that is restructuring may incur high costs to improve the business. In this case, be sure to refer to free cash flow, or the money the business has on hand after it pays for its operating expenses, to understand its financial situation.

ROE can also be misleading if a company achieves high income after a long string of losses. The ROE for a single year may not be indicative of management’s operational prowess. Better to consider it in context of other reporting periods. 

Finally, negative equity needs special attention. Because shareholders’ equity is calculated by subtracting total liabilities from total assets, it’s possible for this figure to be a negative number. There are multiple potential reasons for such a scenario. They include significant accumulated losses from prior periods, large dividend payments, borrowing to cover losses instead of issuing more shares and the amortization of intangible assets.  

Whatever the case, if liabilities exceed assets, shareholders’ equity will be negative and may produce a negative ROE. Such cases warrant further examination before investing, to understand why the liabilities are exceeding assets. 

You need three figures to calculate ROE: 

An increase in ROE is due to some combination of higher net income and/or a reduced value in shareholders’ equity. 

Lower ROE is caused by the company reporting less net income and/or increased shareholders’ equity. 

A company with consistent ROE metrics is generating profits above their cost of capital, regardless of changes to business circumstances or the economy, and is creating value for its shareholders. 

Rising ROE indicates that the company’s operations are becoming more efficient at producing profitable growth for its shareholders. 

A good ROE is typically considered to be equal to or above the average for the company's sector or industry. For example, if the industry average is 18%, then an ROE of 20% is considered to be good or above average. It is important to compare ROE within the same industry because different industries could have different capital structures and profitability norms.