Return on Average Equity (ROAE)

Meaning and definition of return on average equity

The return on average equity (ROAE) refers to the performance of a company over a financial year. This ratio is an adjusted version of the return of equity that measures the profitability of a company. The return on average equity, therefore, involves the denominator being computed as the summation of the equity value at the beginning and the closing of a year, divided by two.

As explained by Investopedia, estimating the return on average equity can provide a more accurate picture of the company’s corporate profitability, particularly in situations where the value of shareholders’ equity has changed significantly during the financial year. In circumstances, where the value of shareholders’ equity does not alter or alters by a small amount during a specific period, the Return on Equity and the Return on Average Equity numbers should be similar, or identical.

Formula for computing return on average equity

ROAE = Net Income / Avg Stockholders' Equity

Computing the Return on Average Equity

The return on average equity is a financial ratio that measures the profitability of a company in relation to the average shareholders’ equity. This financial metric is expressed in the form of a percentage which is equal to net income after tax divided by the average shareholders’ equity for a specific period of time.

The main steps involved in the computation of Return on average equity are:

1. Establish the balance sheet or the Statement of Shareholder’s Equity. After doing this, obtain the common shareholders’ equity for the most recent year (CSE 1) and also the same for previous year (CSE 2).

2. Compute the average common shareholders’ equity (AvgCSE) for the current year and the previous year as:

AvgCSE = (CSE 1 + CSE 2) / 2

3. Find out the Net Income for the year for which the ROAE is to be estimated. The net income can be found near the foot of the income statement for the current year.

4. As a final point, compute the Return on Average Equity as

ROAE = NI / AvgCSE

thus obtaining the return on average equity of the company being analyzed.