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 ju ...

net income In business and accounting, net income (also total comprehensive income, net earnings, net profit, bottom line, sales profit, or credit sales) is an entity's income minus cost of goods sold, expenses, depreciation and amortization, interest, a ...

(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 ins ...

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 Com ...

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 Return on capital (ROC), or return on invested capital (ROIC), is a ratio used in finance, valuation and accounting, as a measure of the profitability and value-creating potential of companies relative to the amount of capital invested by sharehold ...

, 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 f ...

, in association with other

financial ratio A financial ratio or accounting ratio is a relative magnitude of two selected numerical values taken from an enterprise's financial statements. Often used in accounting, there are many standard ratios used to try to evaluate the overall financia ...

s. 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 c ...

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 de ...

financing relative to equity financing. Interest payments to creditors are tax-deductible, 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 Investopedia is a financial media website headquartered in New York City. Founded in 1999, Investopedia provides investment dictionaries, advice, reviews, ratings, and comparisons of financial products such as securities accounts. 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 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 (ROA) of that debt exceeds the interest rate on the debt.Bodie, Kane, Markus, "Investments" :

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Notes

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