Return on Equity (ROE) and Income Statement Analysis

Return on Equity Explained

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Return on equity (ROE) reveals how much profit a company earned in comparison to the total amount of shareholders' equity found on the balance sheet. In other words, return on equity represents the percentage of investor dollars that have been converted into earnings, showing how efficiently the company management is allocating its capital.

Below, we'll define return on equity and show how ROE is calculated, and how it can be used to evaluate the profitability of a company.

Definition and Example of Return on Equity

One of the most effective profitability metrics for investors is a company's return on equity (ROE). ROE shows how much profit a company generates from its shareholders' equity.

Net Income

The profit of a company is called "net income," which is the revenue remaining after all expenses have been deducted. As a result, net income is located at the bottom of the income statement, which is why it's often referred to as the "bottom line." A company's profit or net income is also called "earnings."

Shareholders' Equity

When publicly traded companies want to raise cash, they may issue shares of stock. Investors who purchase these shares own equity in the company. Ideally, if the management team invests the money raised from its share issuance wisely, then sales and revenue would increase, leading to higher profits and a higher stock price.

The amount of shares issued is located on the shareholders' equity section of the balance sheet along with retained earnings, which represents the cumulative total of saved profit over the years. Shareholders' equity is equal to total assets minus total liabilities. Shareholders' equity is a product of accounting that represents the assets created by the retained earnings of the business and the paid-in capital of the owners.

All else being equal, a business with a higher return on equity is more likely to be one that can better generate income with new investment dollars. ROE is shown as a percentage representing the total return on a company's equity capital.

Example of Return on Equity

For example, Bank A has an ROE of 8% for the year, while Bank B has an ROE of 12% for the same period. We can see that Bank B is generating more profit for each invested dollar from shareholders' equity. Investors would need to delve into the reasons why Bank A had a lower ROE than Bank B. Perhaps the management of Bank A made poor investment decisions, or there's idle cash sitting on the balance sheet and not being put to use to generate earnings.

The key to finding stocks that are lucrative investments in the long run often involves finding companies that are capable of consistently generating an outsized return on equity over many decades. Calculating return on equity, as shown below, can help investors find potential investable companies. However, it's important to note that no single financial ratio provides an all-inclusive measurement of a company's financial performance.

How Return on Equity Works

To calculate the return on equity, you need to look at the income statement and balance sheet to find the numbers to plug into the equation provided below.

ROE Formula

Return on Equity = Net Income ÷ Average Common Stockholder Equity for the Period

Let's say the net income for Company XYZ in the last period was $21,906,000, and the average shareholders' equity for the period was $209,154,000.

  • ROE = $21,906,000 (net income) ÷ $209,154,000 (avg. shareholders' equity)
  • ROE = 0.1047, or 10.47% (after multiplying 0.1047 by 100 to convert to a percentage)

By following the formula, the return that XYZ's management earned on shareholder equity was 10.47%. However, calculating a single company's return on equity rarely tells you much about the comparative value of the stock since the average ROE fluctuates significantly between industries. It's best to add context to a company's ROE by calculating the ROE of competitors in the sector.

For large companies, the S&P 500 index may be a good measuring stick for comparison, because it includes many of the biggest public companies in the U.S. and accounts for roughly 80% of the total available market capitalization.

In January 2020, NYU professor Aswath Damodaran calculated the average return on equity for dozens of industries. Taken as a whole, his data determined that the market average is a little more than 13%.

Variations on the ROE Calculation

The return on equity calculation can be as detailed and complex as you desire. Most often, the calculation accounts for the most recent 12 months. However, some analysts prefer alternate methods of calculating a company's ROE.

Annualizing Quarters

Some analysts will actually "annualize" the recent quarter by taking the current income and multiplying it by four. This approach is based on the theory that the resulting figure will equal the annual income of the business.

However, if you aren't careful about the type of business you're annualizing, this can lead to grossly inaccurate results. Retail stores, for example, make roughly 20% of their sales between November 1 and December 31. For hobby, toy, and game stores, that figure is closer to 30%. Therefore, annualizing sales during the busy holiday season won't give you an accurate idea of their actual annual sales. Investors should be careful not to annualize the earnings for seasonal businesses.

The DuPont Model

The DuPont Model is another well known, in-depth way of calculating return on equity. It helps investors figure out what specific factors are going into the return on equity for a company.

DuPont Model ROE Formula

Return on Equity = Net Profit Margin x Asset Turnover x Equity Multiplier

The net profit margin is generally net income divided by sales. Asset turnover is revenue divided by assets. The equity multiplier is assets divided by shareholder equity.

Key Takeaways

  • Return on equity (ROE) reveals how much profit a company earned compared to the total amount of shareholders' equity.
  • Return on equity represents the percentage of investor dollars that have been converted into earnings.
  • Return on equity can be calculated by dividing net income by average shareholders' equity and multiplying by 100 to convert to a percentage.
  • ROE shows how efficiently the company's management is allocating its capital.
  • It's best to compare a company's ROE with those of other companies within the same industry.

Article Sources

  1. Nasdaq. "Return on Equity (ROE) Definition."

  2. Nasdaq. "Stockholder Equity Definition."

  3. Fidelity Investments. "Management and Growth Ratios."

  4. Federal Deposit Insurance Company. "Equity/Assets and ROE of S&P 500 Companies," Page 1.

  5. S&P Dow Jones Indices. "S&P 500."

  6. NYU Stern School of Business. "Return on Equity by Sector (U.S.)."

  7. National Retail Federation. "Winter Holiday FAQs."

  8. Nasdaq. "Net Profit Margin Definition."

  9. Nasdaq. "Total Asset Turnover Definition."

  10. Nasdaq. "Equity Multiplier Definition."