Return on Equity (ROE) - Definition, Example and Calculation: FKnol.com

Return on Equity (ROE) is one the most popular financial ratios which offers a simple figure to indicate the investment returns of a company. It also provides necessary insight into the efficiency and adeptness of the company management for using equity capital to grow the business. A higher positive value is desired, and an increasing value over time indicates that the company management is doing great in generating shareholder value. On the contrary, a declining ROE value over time may be a red flag, as it may indicate that the company management is performing poorly and perhaps investing capital in unproductive assets which are not generating the desired profits. ROE is considered to be one of the best profitability ratios when assessing a company's performance.

Formula to Calculate Return on Equity (ROE)

Calculation of ROE ratio is simple and involves two figures which are available in the financial statements.

ROE = Net Income / Shareholders' Equity

where,
◐ Net Income = Annual Net Income, which is available as a standard line item in company's annual Income Statement, and
◐ Shareholders' Equity is the line item usually titled 'Total Equity' under section 'Stock Holders Equity' of the Balance Sheet.

Though both these figures are readily available in the financial statements, slight clarity is useful. The net income is the amount of income generated by the company for the given year, after deducting all necessary expenses and taxes. The shareholders' equity is the amount that indicates how the company has been funded with the help of equity capital, and it comprises of common shares and preferred shares.

One must note that ROE ratio is calculated on an annual basis, so data from company's annual financial statements should be taken into consideration. The ROE figure is usually expressed as a percentage (%)

DuPont Formula Representation for ROE

Another way to represent or calculate ROE is a product of company's Net Profit Margin, Asset Turnover, and Financial Leverage. These are defined as:

Net Profit Margin = Net Income / Sales

Asset Turnover = Sales / Total Assets

Financial Leverage = Total Assets / Shareholders' Equity

Essentially, all the denominators get cancelled by the next numertor, leaving behind the basic formula for ROE.
However, since the three figures are readily available - Net Profit Margin, Asset Turnover, and Financial Leverage - they can be simply multiplied to get the ROE value.

Asset-Levarage Representation for ROE

ROE is also represented and computed as a product of Return on Asset and Leverage Factor. These are defined as:

Return on Asset = Net Income / Total Assets

Leverage Factor = Total Assets / Equity

Since the denominator cancels the numerator for Total Assets, it reduces to the same standard formula. However, as Return on Asset and Leverage are two easily available factors, it may be easy to multiply the two to get the ROE value.

Example of Return on Equity (ROE)

In this article, we will look at the following real-world examples of recent times for calculating ROE.

ROE Example No. 1:
The NASDAQ-listed Amazon.com Inc (AMZN) belongs to the Consumer Services sector and is categorized under the Catalog and Specialty Distribution subsector. Amazon.com, Inc., incorporated on May 28, 1996, offers a range of products and services through its Websites. The Company operates through three segments: North America, International and Amazon Web Services ...Detailed Company Profile.
As per the annual results dated Jan 31, 2021, the AMZN stock has reported the following figures for:

Financial Item	Value (in USD thousands)
Net Income (from Income Statement)	21,331,000
Total Equity (from Balance Sheet)	93,404,000
Return on Equity (ROE)	= (Net Income / Total Equity)
	= 21,331,000 / 93,404,000
	= 22.84%

In this case of AMZN stock, the ROE value is positive, which indicates that company managed to generate income during the given year. The company generated $22.84 for every $100 it used as its Total Equity.

ROE Example No. 2:
The NYSE-listed Wal-Mart Stores, Inc. (WMT) belongs to the Consumer Services sector and is categorized under the Department Specialty Retail Stores subsector. Walmart Inc. engages in the retail and wholesale operations in various formats worldwide. The company operates through three segments: Walmart U.S., Walmart International, and Sam's Club. It operates ...Detailed Company Profile.
As per the annual results dated Jan 31, 2021, the WMT stock has reported the following figures for:

Financial Item	Value (in USD thousands)
Net Income (from Income Statement)	13,510,000
Total Equity (from Balance Sheet)	80,925,000
Return on Equity (ROE)	= (Net Income / Total Equity)
	= 13,510,000 / 80,925,000
	= 16.69%

In this case of WMT stock, the ROE value is positive, which indicates that company managed to generate income during the given year. The company generated $16.69 for every $100 it used as its Total Equity.

ROE Example No. 3:
The NASDAQ-listed Apple Inc. (AAPL) belongs to the Technology sector and is categorized under the Computer Manufacturing subsector. Apple Inc., incorporated on January 3, 1977, designs, manufactures and markets mobile communication and media devices, personal computers and portable digital music players. The Company sells a range of related ...Detailed Company Profile.
As per the annual results dated Sep 26, 2020, the AAPL stock has reported the following figures for:

Financial Item	Value (in USD thousands)
Net Income (from Income Statement)	57,411,000
Total Equity (from Balance Sheet)	65,339,000
Return on Equity (ROE)	= (Net Income / Total Equity)
	= 57,411,000 / 65,339,000
	= 87.87%

In this case of AAPL stock, the ROE value is positive, which indicates that company managed to generate income during the given year. The company generated $87.87 for every $100 it used as its Total Equity.

Interpretation of ROE Value

The ROE value calculation is essentially - How much net income did the company generate for every dollar of shareholders' capital it had during the year?

Any company may finance its capital in two forms - debt or equity. The Return on Equity (ROE) value offers useful insights about how the company management is using the funding from equity to improve its business. A ROE value that increases year-on-year indicates robust investments by the company management. If the value is declining over the years, or worse if it is negative, then it shows challenges faced by the company in generating income.
At the end of the day, the company is owned by shareholders. ROE provides the single figure that represents the overall profitability or income generating capacity of the company for the owners and investors of the firm.
While there are no set standards, it is usually recommended that a company should be able to generate a higher ROE percentage figure which is higher than the return available from a similar investment. If an investor is considering investing in one of the two companies which have similar risk profile, they would ideally go for the one which offers them better ROE, all things remaining similar.
As shareholders' equity is equal to a company's assets minus its debt, ROE is considered as the return on net assets.

Comparing ROE Values

◐ ROE Values can be computed and compared on annual basis, depending upon which financial statements are available and the time horizon being analyzed. Care should be taken to use nearly similar duration of study period, as many companies follow differently-timed fiscal year.
◐ It is a standard to check the ROE values of the same company over the last few years to assess its ongoing and past performance. However, it is recommended to use annual values instead of quarterly, to avoid impacts of seasonality patterns.
◐ ROE value comparison among more than one company is common and is encouraged. However, both or all the companies should belong to the same sector or industry.
◐ One must also note that ROE values vary widely across industry sector. For instance, the stocks of companies which are classified as Defensive sector generate relatively lower values of ROE, compared to those from the Consumer Discretionary Stocks. This is attributed to the fact that both these sectors have different risk characteristics and are dependent on the overall economic situation.
◐ Utility companies may have high assets and debt with relatively lower income, so their ROE value may be lower. In contrast, technology companies which have are IP-driven and have lower debt and assets may have higher ROE values.
◐ One must compare the company's ROE to the average industry or sector benchmark value for a particular sector, against which a company's ROE performance can be compared against.
◐ A key ratio to compared ROE is against the Cost of Equity. If the Return on Equity is higher than the Cost of Equity, then the company is generating surplus income. If otherwise, the company is losing money.

Drawbacks of Return on Equity

◐Despite a company having high ROE value, it may not clearly demonstrate the increased risk associated with the high return. If the debt of the company is high, it will increase its leverage factor which will increase the ROE. However, since the debt is high, the risk is also higher, which is not captured in the ROE value.
◐ ROE is prone to get skewed due to corporate actions which may change the number of outstanding shares of a company. If a company goes for share buyback, it reduces the number of outstanding shares in the market which increases the ROE value.
◐ Certain intangible assets or non-monetary items - for instance, trademarks, goodwill, patents and copyrights - are excluded, and these may skew the ROE calculations.
◐ There is also ambiguity around which shareholders' equity value to use. Should it be the one at the start of the period, or the one at the end of the period, or the average of the two? Different analysts may use it differently.
◐ Net Income value used in the numberator is also prone to be substituted by EBITDA or EBIT values, and there are questions regarding adjusting those values for non-recurring items.

The Bottom Line

Like any other financial ratio, Return on Equity (ROE) has its set of own benefits and drawbacks. Solely looking at ROE value may not provide the clear profitability potential of a company's efficiency. A deeper and closer look at the granular details of debt and equity financing, recent corporate actions that may have changed the outstanding shares, and similar other comparative ratios (like Return on Capital Employed - ROCE) is advisable.