The return on equity (ROE) is a measure of the profitability of a business in relation to the equity. 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 ''assets minus liabilities''. ROE measures how many dollars of profit are generated for each dollar of shareholder's equity. ROE is a metric of how well the company utilizes its equity to generate profits.

The formula

: ROE is equal to a

fiscal year A fiscal year (or financial year, or sometimes budget year) is used in government accounting, which varies between countries, and for budget purposes. It is also used for financial reporting by businesses and other organizations. Laws in many ...

net income (after

preferred stock Preferred stock (also called preferred shares, preference shares, or simply preferreds) is a component of share capital that may have any combination of features not possessed by common stock, including properties of both an equity and a debt inst ...

dividends, before

common stock Common stock is a form of corporate equity ownership, a type of security. The terms voting share and ordinary share are also used frequently outside of the United States. They are known as equity shares or ordinary shares in the UK and other Comm ...

dividends), divided by total equity (excluding preferred shares), expressed as a percentage.

Usage

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. ROE is also a factor in

stock valuation In financial markets, stock valuation is the method of calculating theoretical values of companies and their stocks. The main use of these methods is to predict future market prices, or more generally, potential market prices, and thus to profit fr ...

, in association with other financial ratios. 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.

Sustainable growth

* The sustainable growth model shows that when firms pay dividends, earnings growth lowers. If the dividend payout is 20%, the growth expected will be only 80% of the ROE rate. * The growth rate will be lower if earnings are used to buy back shares. If the shares are bought at a multiple of book value (a factor of '' x'' times book value), the incremental earnings returns will be reduced by that same factor (ROE/''x''). * ROE is calculated from the company perspective, on the company as a whole. Since much financial manipulation is accomplished with new share issues and buyback, the investor may have a different recalculated value 'per share' (earnings per share/book value per share).

The DuPont formula

The DuPont formula, also known as the strategic profit model, is a common way to decompose ROE into three important components. Essentially, ROE will equal the net profit margin multiplied by

asset turnover Asset turnover (ATO), total asset turnover, or asset turns is a financial ratio that measures the efficiency of a company's use of its assets in generating sales revenue or sales income to the company. Asset turnover is considered to be an Activity ...

multiplied by ''accounting leverage'' which is total assets divided by the total

asset In financial accounting, an asset is any resource owned or controlled by a business or an economic entity. It is anything (tangible or intangible) that can be used to produce positive economic value. Assets represent value of ownership that can ...

s minus total liabilities. Splitting return on equity into three parts makes it easier to understand changes in ROE over time. For example, if the net margin increases, every sale brings in more money, resulting in a higher overall ROE. Similarly, if the asset turnover increases, the firm generates more sales for every unit of assets owned, again resulting in a higher overall ROE. Finally, increasing accounting leverage means that the firm uses more

debt Debt is an obligation that requires one party, the debtor, to pay money or other agreed-upon value to another party, the creditor. Debt is a deferred payment, or series of payments, which differentiates it from an immediate purchase. The ...

financing relative to equity financing. Interest payments to creditors are

tax-deductible Tax deduction is a reduction of income that is able to be taxed and is commonly a result of expenses, particularly those incurred to produce additional income. Tax deductions are a form of tax incentives, along with exemptions and tax credits. T ...

, but dividend payments to shareholders are not. Thus, a higher proportion of debt in the firm's capital structure leads to higher ROE.Profitability Indicator Ratios: Return On Equity
, Richard Loth '' Investopedia'' Financial leverage benefits diminish as the risk of defaulting on interest payments increases. If the firm takes on too much debt, the

cost of debt In economics and accounting, the cost of capital is the cost of a company's funds (both debt and equity), or from an investor's point of view is "the required rate of return on a portfolio company's existing securities". It is used to evaluate ne ...

rises as creditors demand a higher risk premium, and ROE decreases. Increased debt will make a positive contribution to a firm's ROE only if the matching

return on assets The return on assets (ROA) shows the percentage of how profitable a company's assets are in generating revenue. ROA can be computed as below: :\mathrm = \frac This number tells you what the company can do with what it has, ''i.e.'' how many doll ...

(ROA) of that debt exceeds the interest rate on the debt.Bodie, Kane, Markus, "Investments" :

\mathrm = \frac\times\frac\times\frac

Notes

External links