Return on Equity (ROE) and Income Statement Analysis

Understanding return on equity, or ROE, is one of the most fundamental steps to gaining insight into the economic characteristics and attractiveness of a potential investment.
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One of the most important profitability metrics is a return on equity (ROE). Return on equity reveals how much after-tax profit a company earned in comparison to the total amount of shareholder equity found on the balance sheet. In other words, it tells investors how efficiently the company is handling their money. A business that has a high return on equity is more likely to be one that is capable of generating cash internally.

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 and acquiring them at reasonable prices.

Return on Equity Calculation

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

Return on Equity = Net Profit ÷ Average Shareholder Equity for 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

In order 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. Here, we'll use Company XYZ as an example.

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.

If you enter the numbers into the return on equity formula, you get:

$21,906,000 ÷ $209,154,000 = 0.1047 or 10.47%

So, the return that management earned on shareholder equity was 10.47%.

For context, the S&P 500, a measure of the biggest and best public companies in America, averaged returns of equity of 10% to 15% for most of the twentieth century. In the 1990s, the average return on equity was in excess of 20%.

Variations on the ROE Calculation

The return on equity calculation can be as detailed and complex as you desire. Most financial sites and resources take the income available to the common stockholders for the most recent twelve months and divide it by the average shareholder equity for the most recent five quarters. 

Some analysts will actually "annualize" the recent quarter by simply 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. In many cases, however, this can lead to grossly incorrect results. Take, for example, retail stores such as Lord & Taylor or American Eagle. In some cases, 50% or more of the store's income and revenue is generated in the fourth quarter during the traditional holiday shopping period. Investors should be careful not to annualize the earnings for seasonal businesses.

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. The DuPont Model is:

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

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