What is Return on Equity?

By Aniket Bose. Edited By Arjun Chandrasekar

Overview

Return on equity (ROE) is a measure of financial performance which is calculated by dividing net income by shareholders’ equity. Since shareholders’ equity is equivalent to a company’s assets (not including debt), ROE is considered as the return of net assets. ROE is also considered as a measure of a company’s profitably corresponded with stockholders’ equity.

How to Calculate ROE

ROE is expressed as a percentage and can be calculated for any company if both the net income and equity of a company are positive numbers. The net income of a company is calculated before dividends are paid to common shareholders and after dividends are paid to preferred shareholders, along with interest to lenders. Net income is the amount of income and taxes that a company can make for a specific period. 

The average shareholders’ equity is calculated by adding the amount of equity they own at the start of the period. The net income of a company is found on its income statement, which is a sum of the company’s financial transactions over that period. The equity of the shareholders comes directly from the balance sheet, which is a continuous balance of a company’s history of its possession in assets and liabilities. The best way to calculate ROE is based on average equity over some time due to the income statement and balance sheet differences. 

ROE Insights

For a company’s ROE to be determined as good or bad will depend upon what is considered “normal” amongst the shareholders. For instance, a company’s utilities have many assets along with debt on the balance sheet related to a small amount of net income. For most companies, a normal ROE in the utility sector is in the range of 5% to 10%. However, technology and retail firms with smaller balance sheet accounts compared to the net income could have ROE ranging from 18% and above. 

It is beneficial for companies to target an ROE that is equivalent to or a little greater than the other companies in the same sector. For example, suppose Safeway has been able to maintain an ROE of 18% over a couple of years relative to the average ROE of Safeway’s competitors of 15%. After analyzing this situation, an investor could conclude that Safeway is above average at using its assets to generate more profit for the company. A common tactic that is used by investors for considering the return on equity during the long-run average of anything 14% and above to be a good return and anything 10% or below considered as a bad return. 

Conclusion 

In short, ROE is the measure of a company’s net income which is then divided by the value of its total shareholder’s equity, expressed as a percentage. Another way that companies and firms are able to determine the ROE of their shareholders is by dividing the growth rate of dividends by the earnings rate of the dividend. ROE is a two-part ratio in its derivation because it involves a company’s balance sheet and income statement. 

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