Return on equity (ROE) is a financial performance metric that is calculated by dividing a company’s net income by shareholders’ equity.
In simple terms, ROE tells you how efficiently a company uses its net assets to produce profits. Shareholders’ equity is calculated as total assets minus total liabilities.
This is the ROE formula: ROE = Net Income / Shareholders’ Equity.
Net income can be found on the company’s income statement, but shareholders’ equity is listed on the balance sheet. Shareholders’ equity is often simply called equity. It is the same as book value and also called net assets or net worth.
A high return on equity means that a company is good at producing profits. It also means that the business has the potential to grow its earnings in the future.
Why return on equity is important
The higher the ROE, the more effective the company is at producing profits relative to its equity.
In this case, equity is money that has been invested in the business by shareholders, plus money that investors have retained in the business.
In other words, equity is money from investors.
The return on equity gives investors an idea of how effectively a company’s management is using the money invested in it to produce profits.
For example, an ROE of 0.20 or 20% implies that the company can produce 20 cents of profit per year for each dollar of equity.
In other words, if shareholders invest a dollar in the business, the company will turn it into 20 cents of profit per year.
Or if investors let the company retain a dollar of earnings instead of paying it out as dividends, the company will make 20 cents of profit per year from that dollar.
A high return on equity makes it attractive for investors to not only invest in the business but also retain money in the business instead of paying it out as dividends.
Another benefit of having a high return on equity is growth potential. A high number suggests that a company will be able to grow its earnings over time by reinvesting them back into the business.
Formula: How to calculate ROE
The best way to calculate the return on equity formula is by dividing the net income of the last twelve months by the shareholders’ equity.
Using the average of the shareholders’ equity from the beginning and end of the period is the most accurate.
The formula is this: ROE = Net Income / Avg. Shareholders’ Equity.
ROE can be shown as either a ratio or a percentage. To convert from ratio to percentage, you multiply by 100%.
Net income for the last 12 months is usually shown on finance websites as “Net Income (TTM). Preferred dividends are subtracted before calculating the net income in the ROE formula.
If you add up the most recent shareholders’ equity and the shareholders’ equity 12 months ago, then divide by 2, then you have the average shareholders’ equity.
Formula: Avg. Shareholders’ Equity = (SE 1y + SE latest) / 2.
For example, let’s imagine a company that had $5 million in net income in the year 2019. At the start of the year, their shareholders’ equity was $9 million. At the end of the year, the shareholders’ equity had increased to $11 million.
This gives them an average shareholders’ equity of $10 million: (9 + 11) / 2 = 10. Then the ROE is $5 million / $10 million = 0.50 or 50%.
Using the average shareholders’ equity during the past twelve months helps account for the different nature of the balance sheet compared to the income statement.
The income statement shows a time period, like a year, while the balance sheet shows a snapshot of the time it was prepared.
As in, for a company’s financials for a year, the income statement will show everything that happened between January 1 and December 31. But the balance sheet will only show a snapshot of the financial status on December 31.
Using the average shareholders’ equity instead of either the beginning or ending value helps correct for this difference.
What is a good return on equity?
Whether a specific ROE number is good or bad depends on the industry.
Many industries inherently have either a low or high ROI. For example, utilities tend to have low ROE, while profitable tech companies tend to have a high ROE.
Because of this, ROE is mostly useful when comparing similar companies within the same industry.
However, many consider an ROE in the ballpark of 15-20% to be acceptable. To put that in perspective, the S&P500 index had a return on equity of 15.29% in 2019.
But looking at a single ROE number may not be too reliable.
That’s because the return on equity depends on net income, which is a very volatile number that often changes significantly based on one-time accounting items. It can cause ROE to swing wildly from one year to the next.
To get a good idea of whether a company is doing well, it helps to look at how ROE has evolved over time. A stable or rising number is optimal.
However, if ROE is declining over time, then it could indicate that the company is making poor decisions on where to invest its money.
Example of how to use ROE
Let’s imagine that you’re thinking about investing in Facebook stock and want to know how its ROE compares to similar companies.
Calculating the ROE is simple. All we need is the net income and the average shareholders’ equity over the past 12 months.
At the time of writing, Facebook had $18.5 billion in net income in the last 12 months. Their shareholders’ equity 12 months ago was $84 billion, but it is now $101 billion, which gives them an average shareholders’ equity of $92.5.
This makes Facebook’s ROE: $18.5 / $92.5 = 0.2 or 20%.
It is a good ROE, but how does it compare to similar companies?
By comparing Facebook to similar companies that also get the majority of their revenue from digital ads, you see that Facebook’s ROE of 20% is in line with industry peers. It is neither good or bad relative to the industry.
However, if you look at the company’s trends, you will see that they actually had higher ROE in previous years. So it makes sense to check whether the net income for the last 12 months was affected by one-time charges.
In this case, Facebook’s net income decreased due to a one-time $5 billion fine. If we exclude this item, the adjusted net income is $23.5 billion, and the ROE is much higher at 25.4%.
After looking at several years and excluding one-time items, we see that Facebook’s ROE is actually higher than its closest competitors.
This example shows why it is a bad idea to just look at ROE at a single point in time. It helps to look at how it has evolved over time and see if it was affected by unusual items.
Limitations of ROE
Like most other financial ratios, ROE has several limitations.
Most importantly, the ROE number can change drastically when the inputs into the equation change.
If unusual things cause the net income (numerator) or equity (denominator) to go up or down, then it means that the calculated ROE may not be reliable.
For example, a company that takes on a lot of debt will have decreased shareholders’ equity. That’s because debt is a liability, and shareholders’ equity equals total assets minus total liabilities.
In this case, even if ROE goes up, the stock may have just become a riskier investment by taking on debt.
A company with inconsistent profits can also have wild swings in ROE. A net loss reduces shareholders’ equity, and if a company suddenly switches from losses to profits, the equity number may be so low that the ROE looks very large.
Additionally, stock buybacks lead to reduced shareholders’ equity, so large-scale buybacks can inflate ROE by reducing the equity part of the formula.
For this reason, an ROE number that is very high is something to be suspicious of.
If ROE is either much lower or much higher than companies in the same industry, it means you should investigate further.
Finally, if either net income or shareholders’ equity is negative, the ROE number also becomes negative. A negative ROE is hard to interpret and should probably be ignored by most investors.
Return on equity (ROE) is a great financial ratio to see how efficiently a company’s management uses shareholder money to produce profits.
However, it is just one of many financial ratios and has several limitations. It needs to be considered in context with other financial metrics, as well as the company’s overall prospects.