Return on equity
The return on equity (ROE) is a measure of the
where:- ROE = Net Income/Average Shareholders' Equity [1]
Thus, ROE is equal to a fiscal year's net income (after preferred stock dividends, before common stock dividends), divided by total equity (excluding preferred shares), expressed as a percentage. Because shareholder's equity can be calculated by taking all assets and subtracting all liabilities, ROE can also be thought of as a return on NAV, or assets less liabilities.
Usage
ROE measures how many dollars of profit are generated for each dollar of
ROE is especially used for comparing the performance of companies in the same industry. As with return on capital, a ROE is a measure of management's ability to generate income from the equity available to it. ROEs of 15–20% are generally considered good.[2]
ROE is also a factor in stock valuation, in association with other financial ratios. Note though that, while higher ROE ought intuitively to imply higher stock prices, in reality, predicting the stock value of a company based on its ROE is dependent on too many other factors to be of use by itself.[3]
Both of these are expanded below.
The DuPont formula
The
The application, in the main, is either to
- Splitting return on equity into the three components, makes it easier for cost of debt rises as creditors demand a higher risk premium, and ROE decreases.[5] Increased debt will make a positive contribution to a firm's ROE only if the matching return on assets (ROA) of that debt exceeds the interest rate on the debt.[6]
- Identifying the sources of ROE in this fashion similarly allows dividends. These then feed, respectively, into the terminal value calculation, and / or the dividend discount model valuation result. Relatedly, this analysis allows management to preempt any underperformance vs shareholders' required return,[7] which could then lead to a decline in share price, as, "in order to satisfy investors, a company should be able to generate a higher ROE than the return available from a lower risk investment".[8]
See also
- DuPont analysis
- List of business and finance abbreviations
- Return on assets (RoA)
- Return on brand (ROB)
- Return on capital employed (ROCE)
- Return on capital (RoC)
- Return on net assets (RoNA)
- Leverage effect
Notes
- ^ a b c Jason Fernando (2023). "Return on Equity (ROE) Calculation and What It Means", Investopedia
- ^ a b Richard Loth Profitability Indicator Ratios: Return On Equity", Investopedia
- ^ Rotblut, Charles; Investing, Intelligent (January 18, 2013). "Beware: Weak Link Between Return On Equity And High Stock Price Returns". Forbes. Retrieved November 4, 2018.
- ^ Marshall Hargrave (2022). Dupont Analysis, Investopedia.
- ^ Woolridge, J. Randall and Gray, Gary; Applied Principles of Finance (2006)
- ^ Bodie, Kane, Markus, "Investments"
- ISBN 978-1-119-30616-0
- ^ Staff (2023). Return on Equity. Corporate Finance Institute