Business, Legal & Accounting Glossary
Return on equity (ROE) is a measure of how much in earnings a company generates in a time period compared to its shareholders’ equity. It is typically calculated on a full-year basis (either the last fiscal year or the last four quarters).
Put simply, return on equity is net income divided by owners equity. Because it does not include creditors’ capital, the return on equity ratio shows the return from owners’ capital alone. The return on equity calculation is often refined by using average equity ((beginning equity plus ending equity)/2) in the denominator because net income is generated over the entire reporting period. Other analysts subtract out preferred stock, which often resembles bonds, from the denominator in return on equity. Return on equity can be broken down into three components: Net Margin (net income/sales) X Asset Turnover (sales/assets) X Leverage (assets/equity). Sales and assets are in both numerator and denominator of the equation, so they cancel each other out and leave just the original return on equity ratio. If management can increase profitability (net margin) or efficiency (asset turnover), it can increase return on equity; it can also boost return on equity by using borrowed capital to increase returns (leverage). As with other financial ratios, a company’s return on equity is best compared with those of firms in its industry.
When capital is tied up in a business, the owners of the capital want to see a good return on that capital. Looking at profit by itself is meaningless. I mean, if a company earns $1 million in net income, that’s okay. But it’s great if the capital invested to earn that is only $2.5 million (40% return) and terrible if the capital invested is $25 million (4% return).
Return on investment measures how profitable the company is for the owner of the investment. In this case, return on equity measures how profitable the company is for the equity owners, a.k.a. the shareholders.
ROE=\frac{Net\ Income}{Average\ Shareholders\ Equity}
The “average” is taken over the time period being calculated and is equal to “the sum of the beginning equity balance and the ending equity balance, divided by two.”
Return on equity is expressed as a percentage and measures the return a company receives on its shareholder’s equity. It is a much simpler version of return on invested capital.
In general, the market is willing to pay a higher multiple for stocks with higher ROEs.
As with every ratio, ROE should be compared to the company’s industry and competitors. If American Eagle Outfitters is earning 35% ROE, that may sound great, but if the industry is earning 40% on average, then the investor should find out why American Eagle is flying lower. Contrariwise, if its competitors are earning 25%, then American Eagle may be a high flyer. However, don’t invest based on just one ratio. Compare several ratios before making a decision.
This breaks ROE down into several components so that one can see how changes in one area of the business changes return on equity.
ROE = (net\ margin) * (asset\ turnover) * (equity\ multiplier)
ROE = \frac{net\ income}{revenue} * \frac{revenue}{total\ assets} * \frac{total\ assets}{equity}
Return on equity grows, all else equal:
While the first two seem fairly straightforward, the third one doesn’t seem to be, but it really is. If revenue-generating assets are purchased through the use of debt (not equity), then the increased amount of net income generated by that greater amount of assets will increase the return on the fixed amount of equity.
Return on equity also ties into how much growth one can expect from a company. When a firm reinvests its net income, then it can be expected to grow. The fastest this can be expected to occur is the return on equity.
This is calculated:
Sustainable\ growth = Retention\ ratio * ROE
Sustainable\ growth = (1 – payout\ ratio) * ROE
Sustainable\ growth = (1 – \frac{total\ dividend\ paid}{net\ income}) * ROE
Common shareholders are interested in what return the company is making on their stake. To account for this, dividends paid out to preferred shareholders should be subtracted from net income before calculating ROE. So,
ROE=\frac{Net\ Income – Preferred\ Dividends}{Average\ Shareholders\ Equity}
Return on invested capital
Shareholder's equity
Net income
Revenue
Net margin
Asset turnover
Leverage
The return on equity ratio measures a company’s net income against total stockholders’ equity. This is a way to monitor changes in income against the overall book value of the company, or how much of a company’s net worth is tied up in its fixed assets and liabilities, and how much comes from business activities. In general, a higher ratio is better as this usually indicates lower debt, limited expenses and established assets — signs that a company is making the most of what it has. This can be deceiving, however. Assets may be written off the books due to depreciation and the ratio may be skewed if business growth relies on non-quantifiable input — innovation, sales and talent — as is often the case in service industries. Many investors use the DuPont ROE — a calculation that factors in asset turnover — to further examine this information.
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This glossary post was last updated: 29th November, 2021 | 0 Views.