Return on equity (ROE) is a measure of a company’s financial performance that shows the relationship between a company’s profit and the investor’s return. ROE illustrates how much profit a company generates with the money shareholders have invested and how successful the firm’s management team is at turning the cash put into the business into greater gains and growth for the company and investors. The higher the ROE, the more efficient the company's operations are at making use of those funds.
ROE affects how quickly a firm can grow internally by reinvesting earnings. When a company makes money, it can reinvest the funds in the firm or pay out the earnings as dividends to investors, or some combination of the two. In addition, ROE is useful for comparing a company’s profitability with that of its competitors. Averaging ROE over time, for example 5 or 10 years, can provide insight into a company’s growth history. Comparing five-year average ROEs within a specific sector helps pinpoint companies with competitive advantage and the ability to provide shareholder value.
Companies cannot increase their earnings faster than they can boost their ROE without raising additional cash by taking on new debt or selling more shares. However, increasing debt erodes net income and selling more shares squeezes earnings per share by boosting the number of shares outstanding. ROE puts a “speed limit” on a firm's growth rate – which is why money managers rely on it to help determine growth potential. When evaluating companies’ earnings potential, professional investors typically look for ROE of 15 percent or higher.
ROE is typically expressed as a percentage (although it is sometimes referred to as a ratio). The most commonly used formula to calculate ROE is to divide annual net income by shareholder’s average equity for the same period. Net income appears on the company’s income statements, and shareholders’ equity, which shows the difference between total assets and total liabilities, appears on the company’s balance sheet.
ROE = net income / shareholders’ equity
Variations of the basic formula for calculating ROE are as follows:
- To determine the return on common equity (ROCE), subtract preferred dividends from net income and subtract preferred equity from shareholders' equity, or ROCE = net income - preferred dividends / common equity.
- ROE may also be calculated by dividing net income by the average shareholder equity. Average shareholder equity is calculated by adding the shareholders' equity at the beginning of a period to the shareholders' equity at period's end and dividing the result by two.
- Another approach is to calculate the change in ROE during a specific period by using the shareholders' equity figure from the beginning of the period as a denominator to determine the beginning ROE. The end-of-period shareholders' equity can be used as the denominator to determine the ending ROE. Calculating beginning and ending ROEs helps investors see the change in profitability over the period.