Return On Equity (ROE)
Return on equity (ROE) is the amount of net income returned as a percentage of shareholders equity. It reveals how much profit a company earned in comparison to the total amount of shareholder equity found on the balance sheet.
ROE is one of the most important financial ratios and profitability metrics. It is often said to be the ultimate ratio or the ‘mother of all ratios’ that can be obtained from a company’s financial statement. It measures how profitable a company is for the owner of the investment, and how profitably a company employs its equity.
Return on equity is calculated by taking a year’s worth of earnings and dividing them by the average shareholder equity for that year, and is expressed as a percentage:
ROE = Net income after tax / Shareholder's equity
Instead of net income, comprehensive income can be used in the formula's numerator (see statement of comprehensive income).
Return on equity may also be calculated by dividing net income by the average shareholders' equity; it is more accurate to calculate the ratio this way:
ROE = Net income after tax / Average shareholder's equity
Average shareholders' equity is calculated by adding the shareholders' equity at the beginning of a period to the shareholders' equity at the period's end and dividing the result by two.
A common way to break down ROE into three important components is the DuPont formula, also known as the Strategic Profit model. Splitting the return on equity into three parts makes it easier to understand the changes in ROE over time.
ROE (DuPont formula) = (Net profit / Revenue) * (Revenue / Total assets) * (Total assets / Shareholder's equity) = Net profit margin * Asset Turnover * Financial leverage
Norms and Limits
Historically, the average ROE has been around 10% to 12%, at least in the US and UK. For stable economics, ROEs more than 12-15% are considered desirable. But the ratio strongly depends on many factors such as industry, economic environment (inflation, macroeconomic risks, etc.).
The higher the ROE, the better. But a higher ROE does not necessarily mean better financial performance of the company. As shown above, in the DuPont formula, the higher ROE can be the result of high financial leverage, but too high financial leverage is dangerous for a company's solvency.
Exact Formula in the ReadyRatios Analytic Software
ROE (net profit version) = F2[ProfitLoss]*(365/NUM_DAYS)/((F1[b][Equity] + F1[e][Equity])/2)
ROE (comprehensive income version) = F2[ComprehensiveIncome]*(365/NUM_DAYS)/((F1[b][Equity] + F1[e][Equity])/2)
F2 – Statement of comprehensive income (IFRS).
F1[b], F1[e] - Statement of financial position (at the [b]egining and at the [e]nd of the analysed period).
NUM_DAYS – Number of days in the the analysed period.
365 – Days in year.
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