Return on Equity (ROE) and Income Statement Analysis

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One of the most important profitability metrics for investors is a company's return on equity (ROE). Return on equity reveals how much after-tax income a company earned in comparison to the total amount of shareholder equity found on the balance sheet. In other words, it conveys the percentage of investor dollars that have been converted into income, giving a sense of how efficiently the company is handling their money. 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.

The key to finding stocks that are lucrative investments in the long run often involves finding companies capable of consistently generating an outsized return on equity over many decades. Once you've found a company with this pattern, then you must try to acquire stock in that company at reasonable prices.

Return on Equity Calculation

The formula for return on equity is simple and easy to remember.

ROE Formula

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

Shareholder equity is equal to total assets minus total liabilities. Shareholder 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.

Example of Return on Equity

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 above.

Let's say the earnings for Company XYZ in the last period were $21,906,000, and the average shareholder equity for the period was $209,154,000.

ROE Example

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

ROE = $21,906,000 ÷ $209,154,000

ROE = 0.1047, or 10.47%

By following the formula, the return 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, since that index 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.