Return on equity (ROE) is a financial ratio that measures a company’s profitability and how well it generates profits, as well as its overall financial health. ROE is the return produced by the company’s net assets. ROE has become more commonly used since the late 1970s, according to the Federal Reserve Bank of New York. A company’s ROE is separate and different from its return on assets, or “ROA.”
What Is Return on Equity (ROE)?
ROE is a measure of a corporation’s profitability over time. It’s expressed as a percentage that often ranges anywhere from about 10 percent to 80 percent or even more.
However, ROE is only a useful tool when comparing similar companies and enterprises that are in the same sector. Company A, which engages in technology, might have a much different ROE than Company B, which produces oil and gas. Some industries produce higher ROEs than others simply by the nature of their business.
ROE is a combination of data that’s included on a company’s income statement and balance sheet. The shareholders' equity (the difference between total liabilities and total assets) is measured against net profit. Harvard Business Review says that this provides an indication of how much profit is earned from each $1 of the shareholders’ equity.
Why Is ROE Important?
ROE can quickly and easily gauge potential investment returns. One company might be revealed as much more inviting than another when each is compared to its industry average. ROE can also reveal if and to what extent a company is using its equity financing to grow. A negative ROE indicates that each $1 of the shareholders’ equity is losing money.
A savvy stock market investor might want to zero in on a corporation with a ROE that gradually and consistently increases over time. This generally means that the company’s management is successfully reinvesting its earnings to boost profits. You’ll know if you’re getting a good return on your money if you look at the ROE of a company you’ve already invested in, again in comparison to the corporation’s previous ROEs, performance and the industry average.
Return on Equity (ROE) Formula
Determining a corporation’s return on equity is a matter of simple math. The most common ROE formula or metric is annual net income divided by the denominator of the annual shareholders’ equity, or the company’s assets minus its debts. This indicates an average ROE over a year’s time, either calendar year or fiscal year.
You can usually find net income information on the company’s financial statements, including its Consolidated Statement of Earnings, if it files with the U.S. Securities and Exchange Commission. The shareholders’ equity should appear on its balance sheet. It may appear as “book value,” a value per share.
Other Formula Options
You can also divide its dividend growth rate by its earnings retention rate if you have access to this information. A method known as the DuPont Formula, or DuPont Analysis, can be used as well. However, this is more complicated because it’s based on three components rather than two.
Be wary of share buybacks. The Corporate Finance Institute indicates that the number of outstanding shares is reduced when a company repurchases its shares, causing its ROE to rise artificially.
Frequently Asked Questions
What Does 20 Percent Return on Equity Mean?
A 20 percent ROE means that the company has produced 20 cents in profit for each dollar invested, according to the University of Alaska Anchorage. It indicates that dollars invested aren’t born of returns from previous investments when additional investments spike assets on its balance sheet.
What Does a Good ROE Mean for a Company?
A good ROE is a high ROE. It means that a corporation is generating income, not just adequately but pretty well. It also tells an investor that the corporation is superior to other similar investments if its ROE is higher than those of other companies in the same sector.
But “good” ROE percentages can vary significantly by industry so it’s important to compare apples to apples, not to oranges. What might seem like a low ROE might actually be excellent.
According to the NYU Stern School of Business, the average unadjusted return on equity of 80 computer services corporations was just 12.15 percent in January 2023. Average ROE dropped to a mere 5.28 percent for 23 alcoholic beverage companies, and it skyrocketed to 74.08 percent for 19 coal-related companies. So, the bottom line is that a computer services organization would have a “good” ROE at 20 percent, while this number would be painfully low ROE for a coal producer.
- Corporate Finance Institute: Return on Equity (ROE)
- Harvard Business Review: A Refresher on Return on Assets and Return on Equity
- Federal Reserve Bank of New York: Why Do Banks Target ROE?
- University of Alaska Anchorage College of Business and Public Policy: Return on Equity
- NYU Stern School of Business: Return on Equity by Sector (US)
Beverly Bird has been writing professionally for over 30 years. She is also a paralegal, specializing in areas of personal finance, bankruptcy and estate law. She writes as the tax expert for The Balance.