What is return on equity

Return on equity is a common calculation because of its simplicity and insights into the financial health of a company. Most businesses will have a balance sheet and an income statement, which are the two financials that the components of ROE come from. In addition, the ROE calculation doesn’t require a complex calculation. Both net income and shareholder equity numbers can be pulled from the financial statements.

Calculating Return on Equity

Return on equity divides net income by shareholders’ equity. Net income is found by looking at the bottom-line number on the income statement. On the contrary, shareholders’ equity is found on the balance sheet and will be comprised of different components based on your entity structure. For example, a corporation will have common stock, additional paid-in capital, and retained earnings found in its equity section.

Nevertheless, shareholder equity shows a company’s net assets since total assets minus total liabilities equals shareholder equity. This formula is also known as the accounting equation. Here is the equation for calculating return on equity:

Return on Equity = Net Income / Shareholder Equity

Since the income statement is created over a period of time and the balance sheet is generated at a point in time, some investors and business owners prefer to include an average equity balance in the calculation. This creates the following return on equity formula:

Return on Equity = Net Income / (Beginning Shareholder Equity + Ending Shareholder Equity / 2)

By taking the average of beginning and ending equity balances, you are able to see the performance of your company over the same timeframe that net income is shown for. It’s also important to note that return on equity is generally calculated before dividends are paid to common shareholders.

DuPont Analysis Return on Equity

The above return on equity formulas are the easiest to calculate; however, there is another formula called the DuPont analysis. This calculation breaks down ROE into additional steps to reveal the factor that contributes most to the final calculation output. Here is the formula:

ROE = NPM x Asset Turnover x Equity Multiplier

NPM is your net profit margin, which measures your operating efficiency. This number is found on the income statement by dividing net profit by total revenue. Asset turnover measures asset efficiency and is found by dividing net assets by total sales. Equity multiplier evaluates the financial leverage of your company by dividing shareholders’ equity by total assets.

Evaluating Return on Equity

Understanding how to evaluate return on equity is important to maximize your insight into your performance or the financial health of a potential investment. A higher ROE is more favorable, indicating the company is effectively using the company’s assets to create profit. In addition, ROE is meant to be a positive number. If net earnings or the overall capital structure is negative, the ROE calculation will produce a negative number. This means that the company does not have adequate financial leverage and changes to operations need to be made.

Return on equity can also be used to pinpoint risks. An extremely high return on equity can happen if the equity account is smaller compared to net income. For example, if you just had another capital raising round and added a dozen more total shareholders, your equity account will jump up in value. If you add these items right before year-end, you wouldn’t have the time to effectively deploy the new equity and generate stronger returns, creating an inconsistent return on equity.

If you haven’t had any significant equity transactions during the year and are calculating a high ROE, you may need to dig deeper into the issue. You might find that you are overleveraged with debt or have inconsistent profits, both of which can be red flags to prospective investors. Smoothing your ROE and generating consistency are important.

When evaluating return on equity, comparing your calculation to industry benchmarks is beneficial. Let’s say you are in the technology sector and the average return on equity is 15%. If your business is only showing 5%, you may be underperforming compared to your competitors. ROE can vary from industry to industry, which is why many investors and business owners deem a ROE of less than 10% to be poor.

Analyzing Stock Performance with Return on Equity

Return on equity is a versatile calculation that allows investors and business owners to understand current stock performance. Let’s cover how this calculation helps in the decision-making process and future outlook of a stock.

Future Growth Rate

Investors calculate ROE to estimate a stock’s growth rate and how dividends are growing. To generate a company’s future growth rate, ROE is multiplied by a company’s retention ratio. A retention ratio is the percent of net earnings that is reinvested into the company and is usually found by subtracting dividends from net income.

Members of your internal management should frequently calculate future growth rates. This information tells you if your actions align with your strategic goals and can help you understand how investors evaluate your company.

Sustainable Growth Rate

A sustainable growth rate is found by multiplying ROE by the retention rate or taking the ROE times one minus the payout ratio. Let’s say that your company has a return on equity of 20% and a retention ratio of 70%. Multiplying 0.20 by 0.70 generates a sustainable growth rate of 0.14 or 14%.

If your stock is growing at a slower rate than the sustainable growth rate, your stock might be undervalued. However, a growth rate significantly above the sustainable rate highlights an overvalued stock, presenting more risks.

Summary

• Return on equity is found by dividing total shareholders’ equity by net income.
• Return on equity is used to evaluate how well a company is using its net assets to generate income.
• The DuPont ROE calculation allows investors and business owners to identify the factors swaying the calculation.