Definition
The financial metric return on equity, or ROE, is a profitability ratio that analyzes management's ability to earn a fair return on the shareholders' investment. Only two variables are required to determine return on equity: net income and stockholder's equity.
Calculation
Return on Equity (%) = (Net Income / Stockholder's Equity) x 100
Where:
Stockholder's Equity = the average shareholders' equity throughout the year, typically found by adding two yearend values and dividing by two.
Explanation
Return on equity allows the analyst to understand the relationship between the profits generated by the company and the capital available in the form of stockholder's equity, also known as owner's equity. Since ROE does not consider liabilities (debt), management can utilize additional leverage to increase return on equity.
Several profitability ratios examine the relationship between revenues and income. Return on equity is a measure that relies on the balance sheet as well as the income statement. The return on equity for any company will always be equal to, or greater than, the company's return on assets.
When drawing conclusions about the relative performance of a company, benchmark comparisons should be made with competitors in the same industry.
Example
The income statement for Company A indicates net income of $4,283,000 in the current year. Company A's balance sheet indicates stockholder's equity of $15,663,000 in the prior year and $15,420,000 in the current year. The return on equity for Company A would be:
= ($4,283,000 / (($15,663,000 + $15,420,000) / 2)) x 100
= ($4,283,000 / ($31,083,000 / 2)) x 100
= ($4,283,000 / $15,541,500) x 100, or 27.6%
Related Terms
balance sheet, assets, net income, return on assets, abnormal return
