return on equity
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The return on equity (ROE) is a measure of the profitability of a business in relation to its equity; where: : Jason Fernando (2023)
"Return on Equity (ROE) Calculation and What It Means"
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Thus, ROE is equal to a
fiscal year A fiscal year (also known as a 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. La ...
's
net income In business and Accountancy, 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 (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 C ...
dividends), divided by total equity (excluding preferred shares), expressed as a percentage. 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 NAV, or ''assets less liabilities''.


Usage

ROE measures how many dollars of profit are generated for each dollar of shareholder's equity, and is thus a metric of how well the company utilizes its equity to generate profits. ROE is especially used for comparing the performance of companies in the same industry. As with return on capital, an 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 association with other financial ratios. Note though that, 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. Both of these are expanded below.


The DuPont formula

The DuPont formula, Marshall Hargrave (2022)
Dupont Analysis
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.
also known as the strategic profit model, is a framework allowing management to decompose ROE into three ''actionable'' components; these "drivers of value" being the
efficiency Efficiency is the often measurable ability to avoid making mistakes or wasting materials, energy, efforts, money, and time while performing a task. In a more general sense, it is the ability to do things well, successfully, and without waste. ...
of operations, asset usage, and finance. ROE is then the net profit margin multiplied by asset turnover multiplied by accounting leverage: :\mathrm = \frac\times\frac\times\frac The application, in the main, is either to financial management or to fund management: *Splitting return on equity into the three components, makes it easier for financial managers 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 Loan, borrowed or otherwise withheld from another party, the creditor. Debt may be owed by a sovereign state or country, local government, company, or an individual. Co ...
financing relative to equity financing. Interest payments to
creditor A creditor or lender is a party (e.g., person, organization, company, or government) that has a claim on the services of a second party. It is a person or institution to whom money is owed. The first party, in general, has provided some propert ...
s 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.Richard Lot
Profitability Indicator Ratios: Return On Equity
,
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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. *Identifying the sources of ROE in this fashion similarly allows investment analysts a better knowledge of the company and how it should be valued. Here, analysts will compare the current sources of ROE against the company's history and its competitors, and thereby better understand the drivers of value. In particular, as mentioned, ROE is used developing estimates of a stock’s growth rate, and hence the growth rate of its
dividends A dividend is a distribution of profits by a corporation to its shareholders, after which the stock exchange decreases the price of the stock by the dividend to remove volatility. The market has no control over the stock price on open on the ex ...
. These then feed, respectively, into the terminal value calculation, and / or the dividend discount model valuation result. Relatedly, this analysis allows management to preempt any underperformance vs shareholders' required return, which could then lead to a decline in the company's shares value, since, "in order to satisfy investors, a company should be able to generate a higher ROE than the return available from a lower risk investment".Staff (2023)
Return on Equity
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See also

*
DuPont analysis DuPont analysis (also known as the DuPont identity, DuPont equation, DuPont framework, DuPont model, DuPont method or DuPont system) is a tool used in financial analysis, where return on equity (ROE) is separated into its component parts. Useful ...
*
List of business and finance abbreviations A list is a set of discrete items of information collected and set forth in some format for utility, entertainment, or other purposes. A list may be memorialized in any number of ways, including existing only in the mind of the list-maker, but ...
* Return on assets (RoA) * Return on brand (ROB) * Return on capital employed (ROCE) * Return on capital (RoC) *
Return on net assets The return on net assets (RONA) is a measure of financial performance of a company which takes the use of assets into account. Higher RONA means that the company is using its assets and working capital efficiently and effectively. RONA is used by in ...
(RoNA) * Leverage effect


Notes

{{Financial ratios Financial ratios Investment indicators