The "return on shareholders investment ratio" provides a quick look at what kind of profit the shareholders of a company are getting for their investment in a particular company. It allows you to compare the return those shareholders are seeing with the return for shareholders of similar companies. More often called "return on equity," or ROE, the ratio involves two numbers drawn from a company's financial statements: stockholders' equity and net income.
Stockholders' equity is the value a company would have after paying off all its debts and other obligations. Take a company's total assets and subtract its total liabilities, and the result is stockholders' equity. Net income is essentially profit -- a company's revenue minus its expenses. The ROE ratio is net income divided by stockholders' equity. For example, if a company has total stockholders' equity of $13 million, and it generated $850,000 in net income last year, the ROE ratio would be $850,000/$13,000,000. As with all fractions, you can reduce this to a percentage, which is how return on shareholders' investment is usually expressed. In this case, it would be 6.54 percent.
ROE in Action
For a real-world example of the ROE ratio, take a look at Microsoft. Federal law requires publicly traded companies to file an annual summary of their financial condition, called a Form 10-K, with the Securities and Exchange Commission. Microsoft's 10-K filing for the end of fiscal year 2011 shows total stockholders' equity of $57.083 billion. For the year, Microsoft reported $23.150 billion in net income. So Microsoft's return on shareholders' investment for fiscal year 2011 was $23.150 billion/$57.083 billion, or 40.55 percent.
Return on Average Equity
The ROE formula described so far does have a bit of a problem: The figure used for stockholders' equity is taken from a specific moment in time -- the end of Microsoft's 2011 fiscal year, which was June 30, 2011. In reality, the total amount of stockholders' equity fluctuated over the course of that fiscal year. Meanwhile, the net income figure represents income for the full one-year period. That's why many investors and analysts prefer a variation on the ROE formula, called "return on average equity." Instead of dividing net income by the amount of stockholders' equity at year's end, you divide the net income by the average amount of equity from the beginning of the year to the end. To get the average, you simply add the equity figure from the start of the year to the equity figure from the end of the year, then divide by two.
Average Equity in Action
Microsoft's 10-K from fiscal year 2011 shows that total stockholders' equity at the end of fiscal 2010 was $46.175 billion. Add that to the total equity at the end of fiscal 2011, $57.083 billion, and you get $103.258 billion. Divide that by two, and you get an average equity of $51.629 billion for fiscal 2011. Now divide the year's net income by the average equity to get the return: $23.150 billion/$51.629 billion, or 44.84 percent.
- "Financial Accounting for MBAs"; Peter D. Easton et al; 2010
- Microsoft: Investor Relations - SEC Filings