Return on equity or ROE is a financial ratio measuring the percentage of net income attributable to shareholders. From one side, it shows the profitability of shareholders’ investments, and from the other side it shows the efficiency of management in using equity financing.
The formula for return on equity is expressed as follows:
|ROE =||Net Income||× 100%|
|Average Shareholders’ Equity|
Generally, ROE is calculated for common shareholders. Thus, we should use:
The value of net income and the amount of preferred dividends (if available) can be found in the income statement and notes to the financial statements.
The average shareholders’ equity is a sum of total shareholders’ equity at the beginning and at the end of the period divided by 2. In turn, the value of total shareholders’ equity can be found in the balance sheet.
Earnings before taxes can also be used to remove the impact of taxation.
|ROE =||Earnings before Taxes||× 100%|
|Average Shareholders’ Equity|
Such an approach is a useful practice when it is required to compare companies operating in jurisdictions with different tax policies.
The balance sheet of XYZ company is as follows:
Balance sheet, US$ in thousands
The reported income statement for the 20X8 financial year is as follows:
XYZ company declared a total amount of preferred dividends of $400,000.
Since the company has both preferred and common stocks outstanding, the common shareholders’ equity at the beginning of the year is $50,970,000 ($52,970,000 - $2,000,000) and $53,930,000 ($55,930,000 - $2,000,000) at the end of the year. Thus, the average common shareholders’ equity is $52,450,000.
|Average common shareholders’ equity 20X8 =||$50,970,000 + $53,930,000||= $52,450,000|
To compute net income attributable to common shareholders, we need to remove preferred dividends of $400,000. Thus, the return on equity of XYZ company is 9.44%.
|ROE 20X8 =||$5,350,000 - $400,000||× 100%||= 9.44%|
Tracking the change of ROE over time is also an important task of analysis. Let’s assume that in the prior year it was 12.37%. The current value of 9.44% compared with the prior baseline of 12.37% indicates that management may not be effectively managing the profits earned based on the owners’ investment in the company.
ROE is a very important ratio from investors’ point of view because it measures the efficiency of how shareholders’ equity is used. Generally, higher values are preferable, but management can artificially influence its value. For example, if a company has high financial leverage, i.e., debt financing is a great proportion of total financing, the return on equity can be much higher than the industry average, which implies a great degree of risk.
While ROE can be used to compare companies from different industries, it should also be compared with other companies in the industry. It helps to determine whether or not a business’s profitability is better than average in the industry. Let’s consider the example above and assume the industry average in the current year is 15.85%.
Return on equity of 9.44% compared with the industry baseline of 15.85% indicates that management is insufficiently effective in generating profit on owners’ investments.
You can also calculate the return on equity using our online calculator.