Return on equity (ROE) is a measure of how much profit an organization generates per share, and is calculated by dividing annual net income by shareholder equity.
ROE is a key metric to look at when assessing a company’s financial performance, and it can be used to measure a company's success at turning shareholder investments into profits by looking at how the company’s management is utilizing its capital.
How is ROE Calculated?
ROE is calculated using the following formula:
Annual Net Income ÷ Shareholder Equity = Return on Equity
Net income is the amount of income a company has generated over a period of time, minus expenses and taxes. Shareholder equity can be obtained by subtracting a company’s total liabilities from its total assets, and can be found on a company's balance sheet.
For example, if net income stands at $1m and shareholder equity is $12m, you can divide the former by the latter and then multiply the result by 100 to gain a percentage value. This lets you work out that the company’s ROE is 8.3%. Once you have the ROE figure, this can help you can make a judgement about the company’s performance and whether or not you want to buy shares in the company.
What is a good ROE?
When determining if a company’s ROE is good or bad, you should always look to other companies in the sector to understand how similar companies are positioned, as companies within different sectors can have unique dynamics which can positively or negatively affect their ROE.
As a general rule, you should look to invest in companies which have an equal or better-than-average ROE compared to peers within the same industry. If possible, you should also look at how this metric has trended over time as an ROE which is consistently at a higher percentage than other companies in the same sector can show that a company’s management team is good at utilizing the company’s capital to create profits compared to competitors.
Although it does differ from one sector to another, a good benchmark for almost all companies is to compare the ROE to the average of the S&P 500, which is approximately 13%. In general, an ROE of 15–20% is considered very good, and an ROE below 10% is seen as less desirable for investors.
What is DuPont ROE?
As demonstrated above, you can calculate ROE by dividing net income by shareholder equity. However, there is an alternative method which includes many extra steps and this is called the DuPont decomposition, having been created by the DuPont company almost a century ago.
The first version of this variant allows you to work out ROE by multiplying a company’s net profit margin, asset turnover and equity multiplier.
The second DuPont ROE variant is significantly more complex. The formula for this method uses operating margin, turnover, borrowing costs, equity and tax rate . Your first step is to multiply operating margin by turnover, before subtracting borrowing costs. Then, you must multiply the resultant figure by equity and then multiply this by one minus the company’s tax rate.
Advantages and disadvantages of ROE
An important advantage to ROE can be seen in the difference between ROE and ROA (return on assets). The latter metric measures a company’s productivity relative to its assets. While this is useful when analysing how well a company is utilising its own assets, ROE offers investors insight into how successfully their investment is being used to make money.
However, ROE can be misleading depending on what stage of its development a company is at. For example, capital requirements can be high for newer companies so they might struggle to record a high ROE. The metric can also be misleading in cases where a company is achieving inconsistent profits or has excessive debt. Additionally, when a company reports negative net income, the calculation will lead to a negative return on equity, although this does not necessarily mean it would be unwise to invest.
