How to Calculate Return on Equity ROE

By the end of Year 5, the total amount of shares bought back by Company B has reached $110m. And the “Total Shareholders’ Equity” account balance is $230m for Company A, but $140m for Company B. To elaborate, Company A shows a higher ROE, but this is due to its higher debt, not greater operating efficiency. In fact, the company with the higher ROE might even suffer too much of a debt burden that is unsustainable and could lead to a potential default on debt obligations. The more debt a company has raised, the less equity it has in proportion, which causes the ROE ratio to increase.

Return on Equity Calculation Example (ROE)

However, ROE compares net income to net assets (assets minus liabilities) of the company, while ROA compares net income to the company’s assets without deducting its liabilities. In both cases, companies in industries in which operations require significant assets will likely show a lower average return. Though ROE looks at how much profit a company can generate relative to shareholders’ equity, return on invested capital (ROIC) takes that calculation a couple of steps further. A good rule of thumb is to target a return on equity that is equal to or just above the average for the company’s sector—those in the same business.

Company

A high ROE is a positive sign to investors, signaling that a company is effectively producing profits with the money invested into it. It’s also a growth signal, as a high number indicates that a business may be able to increase its earnings over time. In a situation when the ROE is negative because of negative shareholder equity, the higher the negative ROE, the better. This is so because it would mean profits are that much higher, indicating possible long-term financial viability for the company.

To understand a company’s ROE number, you can compare it to industry peers and evaluate long-term trends. When assessing ROE, keep in mind that one-time items can affect net income, also affecting ROE. In this case, equity is money that has been invested in the business by shareholders, plus money that investors have retained in the business. It means the company is not generating enough profits to cover its equity, possibly due to losses or high debt.

1. For example, a company that accounts for revenue on an accrual basis might have a different ROE than if it accounted for revenue on a cash basis, even though the long-term revenue is the same.
2. It also indicates how profitable it would have been if all funds invested were shared by the investors and it shows how well a company is efficiently using its assets.
3. In essence, ROE is a measure of a company’s profitability against the capital that shareholders have invested.
4. To understand a company’s ROE number, you can compare it to industry peers and evaluate long-term trends.
5. Therefore, this compensation may impact how, where and in what order products appear within listing categories, except where prohibited by law for our mortgage, home equity and other home lending products.
6. And the “Total Shareholders’ Equity” account balance is $230m for Company A, but $140m for Company B.

Related Terms

The retention ratio is the percentage of net income that is retained or reinvested by the company to fund future growth. Average shareholders‘ equity is calculated by adding equity at the beginning of the period. The beginning and end of the period should coincide with the return on equity meaning period during which the net income is earned.

If the ROE is either much lower or much higher than companies in the same industry, you should investigate further. For example, utility companies tend to have low ROEs, while profitable tech companies tend to have high ROEs. Whether an ROE number should be considered good or bad depends on the industry.

In contrast, a low or negative ROE could signal that the company is having trouble generating income in relation to the value of its assets and liabilities. If you’re comparing two real estate companies with substantial assets, you’d perhaps expect them both to generate substantial income. For investors, evaluating ROE can help you determine whether the company is putting equity capital to good use. If ROE is high and stable, that could be a clue that the company can continue to deliver solid earnings in the future, without having to take on unnecessary debt. A company that aggressively borrows money, for instance, would artificially increase its ROE because any debt it takes on lowers the denominator of the ROE equation. Without context, this might give potential investors a misguided impression of the company’s efficiency.

While ROE measures profitability relative to shareholder equity, ROIC evaluates the return on all invested capital, including debt. ROIC provides a more comprehensive view of a company’s efficiency in utilizing all sources of capital. As with all investment analysis, ROE is just one metric highlighting only a portion of a firm’s financials. Another way to look at company profitability is by using the return on average equity (ROAE). It is critical to utilize a variety of financial metrics to get a full understanding of a company’s financial health before investing.

Therefore, this compensation may impact how, where and in what order products appear within listing categories, except where prohibited by law for our mortgage, home equity and other home lending products. Other factors, such as our own proprietary website rules and whether a product is offered in your area or at your self-selected credit score range, can also impact how and where products appear on this site. While we strive to provide a wide range of offers, Bankrate does not include information about every financial or credit product or service. For that reason, it’s best to look at debt loads and ROA in conjunction with ROE to get a more complete picture of a company’s overall fiscal health. You can also look at other, narrower return metrics such as return on capital employed (ROCE) and return on invested capital (ROIC).

Assume that there are two companies with identical ROEs and net income but different retention ratios. The SGR is the rate a company can grow without having to borrow money to finance that growth. The formula for calculating SGR is ROE times the retention ratio (or ROE times one minus the payout ratio). Firm A looks as though it has higher profitability when it really just has more demanding obligations to its creditors. For a more transparent view that helps you see through this mask, make sure you also examine the company’s return on invested capital (ROIC), which reveals the extent to which debt drives returns. The difference between return on equity (ROE) and return on assets (ROA) is tied to the capital structure, i.e. the mixture of debt and equity financing used to fund operations.

How to calculate return on equity

The term ROE is a misnomer in this situation as there is no return; the more appropriate classification is to consider what the loss is on equity. ROE is expressed as a percentage and can be calculated for any company if net income and equity are both positive numbers. Net income is calculated before dividends paid to common shareholders and after dividends to preferred shareholders and interest to lenders. The process of calculating the return on equity (ROE) is relatively straightforward, as it divides net income by the average shareholders’ equity balance in the prior and current period.