Return on equity (ROE) is a financial performance metric that measures your company’s ability to generate profit from its shareholders’ equity. Your shareholders’ equity is equal to your assets minus debts, so your ROE shows your return on your net assets.
Your ROE expresses how effectively your management uses the company’s assets to create earnings as a percentage. The higher your ROE, the more efficient your use of equity capital.
Expected ROE differs depending on the industry, with high-profit-margin sectors like non-alcoholic beverages averaging 27.4% and capital-intensive areas like biotechnology returning -66.3%.
Why Do Finance Teams Use ROE?
Finance teams create a return on equity report because it offers a clear picture of company profitability relative to the equity shareholders invested. That metric helps with:
- Measuring Profitability: ROE shows finance teams understand the company’s ability to generate earnings from equity. A higher ROE means the company is more efficient at converting shareholders’ equity into profits.
- Comparing Performance: Potential investors use ROE to compare the performance of companies within the same industry. Finance teams can make better investment decisions by choosing companies that manage their equity more effectively.
- Assessing Management Efficiency: ROE serves as an indicator of how well a company’s management team is using shareholders’ equity to drive growth. Consistently high ROE signals strong management efficiency in deploying resources for profitability.
- Guiding Investment Decisions: Investors and finance teams look at their ROE when evaluating the potential returns on their investments. A strong ROE usually means a company is performing well, which attracts more investors and capital.
Return on Equity Formula
Since your ROE measures your profitability in relation to your shareholders’ equity, you need both numbers to calculate your return on equity.
The formula is:
ROE = Net Income / Shareholders’ Equity × 100
Multiplying the result by 100 turns your return on equity calculation into a percentage, making it easier to compare profitability between different companies. For example, an ROE of 15% means that every dollar in equity generates 15 cents in profit.
Logically, a higher ROE suggests a more efficient use of equity capital, so businesses with a high ROE are more likely to secure investment capital.
How to Calculate Return on Equity
Let’s put the formula to work. To calculate the return on equity formula, you need to get two key figures from your financial statements: net income and shareholders’ equity.
- Net Income: Your total profit after taxes, interest, and any other expenses. It’s on your income statement and represents the total earnings or profit after all expenses, taxes, and costs have been deducted.
- Shareholders’ Equity: Your company’s net assets—your total assets minus total liabilities. It reflects the net value that shareholders own in the company.
Using modern financial planning and analysis (FP&A) tools like PivotXL, you can automate these calculations with data pulled directly from your financial statements, saving time and improving accuracy.
Example of ROE Calculation
Let’s say a tech company reports the following:
- Net income: $500,000
- Shareholders’ equity: $2,000,000
Using the ROE formula:
ROE = $500,000 / $2,000,000 × 100 = 25%
The ROE of 25% means that for every dollar of equity invested by shareholders, the company generates 25 cents in profit. A ROE of 25% is exceptionally strong and shows efficient use of equity to create returns.
When to Use the Return on Equity Formula
Here are key situations when it’s most useful to apply the ROE formula:
- Gauging Profitability and Efficiency: ROE shows how effectively a company uses its shareholders’ equity to generate profit, making it attractive to funders.
- Determining Stock Performance: A consistently high ROE suggests a solid record of delivering value to shareholders. It’s particularly useful when comparing companies of similar size and industry.
- Identifying and Evaluating Risks: While a high ROE is generally good, an extremely high ROE might indicate heavy borrowing. Finance teams use ROE to identify high-performing companies and evaluate the sustainability of their returns.
DuPont Analysis: Breaking Down Return On Equity
DuPont Analysis is a powerful framework that dissects ROE into three key components to provide deeper insights:
ROE = Profit Margin × Asset Turnover × Equity Multiplier
1. Profit Margin
Measures how much profit a company generates from its revenue.
Formula: Net Income / Revenue
2. Asset Turnover
Indicates how efficiently a company uses its assets to generate revenue.
Formula: Revenue / Total Assets
3. Equity Multiplier
Reflects the level of financial leverage.
Formula: Total Assets / Shareholders’ Equity
This breakdown helps finance teams and investors identify whether changes in ROE are driven by profitability, asset efficiency, or leverage.
Limitations of Return on Equity
ROE isn’t always the best metric for judging profitability and efficiency. Investment decisions should be based on multiple metrics.
Key considerations include:
- Positive vs. Negative ROE: A positive ROE shows profitability, while a negative ROE might indicate temporary losses during growth phases.
- Impact of Stock Buybacks: Share buybacks lower equity, inflating ROE without actual profitability improvement.
- Focus on Equity, Not Debt: ROE doesn’t account for a company’s debt, which could expose it to financial risks.
- Limited to Tangible Assets: ROE focuses on equity and may not reflect intangible assets like goodwill or intellectual property.
- Vulnerability to Manipulation: Companies can manipulate net income, which affects ROE. Always use multiple metrics to evaluate a company’s financial health.
ROE vs. Other Financial Metrics
Here’s how ROE compares to other profitability measures:
- ROI (Return on Investment): ROI applies to any investment and measures profitability relative to cost.
- ROIC (Return on Invested Capital): ROIC accounts for both debt and equity, offering a broader view of profitability.
- DuPont Analysis: Breaks down ROE into profit margin, asset turnover, and equity multiplier for deeper insights.
- ROA (Return on Assets): Measures how efficiently a company uses all assets to generate profit.
- Rate of Return: Tracks the gain or loss on an investment over time, more general than ROE.
Streamline Your ROE Analysis
While ROE is a vital metric, combining it with ROI, ROIC, and ROA offers a more comprehensive view of financial performance.
Using a robust tool like PivotXL, finance teams can automate complex calculations, streamline data processing, and generate accurate reports for better decision-making. With PivotXL, you can simplify financial analysis and focus on driving growth.
Ready to simplify your financial workflows? Book a demo with PivotXL today!
