Return on Equity (ROE)

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Waseem Alim

Return on Equity equals net income divided by average equity over a given period

Return on Equity is a measure of how profitably a company employs its equity, that is, the money raised from shareholders. Everything else being equal, a higher ROE is better as it means that the company is efficient about using its equity.

Due to the unique nature of each industry and variances in accounting methodologies among them, ROE should normally be used for comparisons within the same industry. For example: The ROE for service-oriented industries, such as the software industry, is significantly higher than that of capital-intensive industries such as the construction industry.

Comparisons of ROE within the same industry can also be misleading as ROE ignores the effect of debt. If a company can issue debt at a lower interest rate than the rate of return on its investments, it could increase its ROE. However, higher debt also increases the risk of failure for the company. Generally, companies with higher debt, as measured by the debt to equity ratio, will have better ROE. An investor could get a better sense of the investment by considering the Return on Assets, which mitigates the influence of debt, alongwith ROE.

Determination of ROE

What are the drivers of ROE? The DuPont Analysis breaks the Return on Equity into three parts that are drivers: net profit margin, asset turnover and leverage.

ROE = (Net profits/Sales) * (Sales/Assets) * (Assets/Equity) = Net profits / Equity

ROE can also be broken down in a two-part equation, similar to the DuPont Analysis, using ROA (Net profits / Assets) and leverage.

ROE = (Net profits / Assets) * (Assets / Equity) = Net profits / Equity

Example

• Company A earned $5 million in net income. Its equity capital in the beginning of the year were $10 million, and at the end of the year were $20 million. Therefore, the company's ROE during the year was 33% [($5 million)/(($10m + $20m)/2)].