What is return on equity (ROE)?
Return on equity is a financial performance metric that measures your company’s ability to generate profit from its shareholders' equity. Your shareholders’ equity is equal to your assets minus debts, so your ROE shows your return on your net assets.
Your ROE expresses how effectively your management uses the company's assets to create earnings as a percentage. The higher your ROE, the more efficient your use of equity capital.
Expected ROE differs depending on the industry, with high-profit-margin sectors like non-alcoholic beverages averaging 27.4%, and capital-intensive areas like biotechnology returning -66.3%.
Why do finance teams use ROE?
Finance teams create a return on equity report because it offers a clear picture of company profitability relative to the equity shareholders invested. That metric helps with:
- Measuring profitability: ROE shows finance teams understand the company’s ability to generate earnings from equity. A higher ROE means the company is more efficient at converting shareholders' equity into profits.
- Comparing performance: Potential investors use ROE to compare the performance of companies within the same industry. Finance teams can therefore make better investment decisions by choosing companies that manage their equity more effectively.
- Assessing management efficiency: ROE serves as an indicator of how well a company’s management team is using shareholders’ equity to drive growth. Consistently high ROE signals strong management efficiency in deploying resources for profitability.
- Guiding investment decisions: Investors and finance teams look at their ROE when evaluating the potential returns on their investments. A strong ROE usually means a company is performing well, which attracts more investors and capital.
Return on equity formula
Since your ROE measures your profitability in relation to your shareholders’ equity, you need both numbers to calculate your return on equity.
The formula is:
ROE = Shareholders’ Equity / Net Income x 100
Multiplying the result by 100 turns your return on equity calculation into a percentage, making it easier to compare profitability between different companies. For example, an ROE of 15% means that every dollar in equity generates 15 cents in profit.
Logically, a higher ROE suggests a more efficient use of equity capital, so businesses with a high ROE are more likely to secure investment capital.
How to calculate return on equity
Let’s put the formula to work. To calculate the return on equity formula, you need to get two key figures from your financial statements: net income and shareholders’ equity.
Your net income is your total profit after taxes, interest, and any other expenses. It’s on your income statement and represents the total earnings or profit after all expenses, taxes, and costs have been deducted.
Your shareholders’ equity represents your company’s net assets—your total assets minus total liabilities. It’s reported on the balance sheet and is essentially the difference between the company’s total assets and total liabilities. It reflects the net value that shareholders own in the company.
This used to be a manual task where you had to copy and paste the figures every time you wanted to calculate the return on equity. But now, financial planning and analysis (FP&A) software can automatically make these calculations using the data from your three financial statements.
Example of ROE calculation
Let’s say a tech company reports the following:
- Net income: $500,000
- Shareholders’ equity: $2,000,000
Using the ROE formula:
ROE = $2,000,000 / $500,000 x 100 = 25%
The ROE of 25% means that for every dollar of equity invested by shareholders, the company generates 25 cents in profit. A ROE of 25% is exceptionally strong and shows efficient use of equity to create returns.
When to use the return on equity formula
Here are the key situations when it’s most useful to apply the ROE formula:
Gauging profitability and efficiency
ROE shows how effectively a company uses its shareholders’ equity to generate profit. Investors can use ROE to compare profitability between companies in the same industry. Therefore, a high ROE shows that a company knows how to use equity well to drive profits, making it attractive to funders.
Determining stock performance
Equity investors frequently use ROE to assess a company’s stock performance. A consistently high ROE suggests the company has a solid record of delivering value to shareholders. It's particularly useful when comparing companies of similar size and industry, helping investors identify which stocks might offer the best return on their investments.
Identifying and evaluating risks
While a high ROE is generally a good thing, extremely high ROEs can sometimes indicate potential risks. For instance, a company with a high ROE but high debt levels might be borrowing heavily to boost its profitability, which could expose it to financial risk if markets turn. Finance teams use ROE to not only identify high-performing companies but also to evaluate the sustainability of those returns.
Limitations of return on equity
As we’ve just hinted at, a return on equity isn’t always the best metric for judging profitability and efficiency. Any investment decisions should be made after analyzing a combination of metrics to get a fuller, more reliable understanding.
Here are some aspects to be aware of when measuring ROE.
- Positive vs. negative ROE: A positive ROE generally indicates that a company is generating profits from shareholders' equity, which is seen as a good sign. However, a negative ROE isn’t always a bad sign. For example, a start-up or a company in a high-growth phase may have high expenses related to expansion, leading to temporary losses.
- Impact of stock buybacks: ROE can be artificially inflated by share buybacks. When a company buys back its own shares, it lowers the denominator (equity) in the ROE equation, making the ratio look better even if net income remains the same. This can give the appearance of improved performance, even when there is no actual increase in profitability.
- Focus on equity, not debt: ROE only takes into account the company’s equity and doesn’t factor in the level of debt. A company with high debt and high ROE might appear profitable, but the debt increases financial risk.
- Limited to tangible assets: ROE focuses solely on equity, which can be skewed if the company has significant intangible assets, such as goodwill or intellectual property.
- Vulnerability to manipulation: Companies can manipulate data through aggressive depreciation policies or capitalizing expenses, which inflates net income and makes ROE look stronger than it really is. Always consider other financial metrics alongside ROE to avoid being misled by such practices.
ROE vs other financial performance measures
There are a whole host of ways to assess a company’s profitability outside return on equity, so let’s see how they compare to ROE.
Return on investment (ROI)
Return on investment is a versatile metric used to measure the profitability of an investment relative to its cost. Unlike ROE, which focuses solely on equity, ROI can apply to any investment, whether it's in securing new forecasting software or hiring third-party collaborators.
The formula is:
ROI = Gain from investment − cost of investment / cost of investment x 100
ROI is broader in scope than ROE and can be used to evaluate the efficiency of various types of investments, not just those funded by equity.
Return on invest capital (ROIC)
Return on invested capital looks at how well a company generates profit relative to all the capital it has invested, including both debt and equity. ROIC is often viewed as a more comprehensive metric than ROE because it accounts for both equity and debt financing, giving a clearer picture of how effectively a company is using its total capital to generate returns.
ROIC = net operating profit after tax (NOPAT) / total invested capital
ROIC is especially useful for comparing companies with different capital structures, as it reflects the returns on both equity and debt.
DuPont Analysis
The DuPont Analysis breaks down ROE into three components to provide more granular insight into a company’s financial performance:
ROE = profit margin x asset turnover x equity multiplier
- Profit margin measures how much profit a company generates from sales.
- Asset turnover shows how efficiently the company uses its assets to generate revenue.
- The equity multiplier reflects the company’s financial leverage.
By breaking ROE into these components, DuPont Analysis helps finance teams identify what is driving changes in ROE, whether it's profitability, asset efficiency, or financial leverage.
Return on assets
Return on assets (ROA) measures how efficiently a company uses its assets to generate profit, regardless of how those assets are financed.
The formula for ROA is:
ROA = net income / total assets x 100
While ROE focuses on shareholders' equity, ROA gives a broader view by looking at how all assets, both equity and debt, are contributing to profitability. ROA is particularly useful for comparing companies in capital-intensive industries.
Rate of return
Rate of return refers to the gain or loss on an investment over time, expressed as a percentage of the initial investment. It can be applied to various types of investments, such as stocks, bonds, or real estate.
The formula is:
Rate of return = current value of investment − initial value / initial value x 100
The rate of return is flexible and can be applied across different asset classes, but it is more general than ROE and does not focus on the profitability derived from equity alone.
Streamline your ROE analysis
While ROE is an important measure of profitability, you need to use it in conjunction with other metrics like ROI, ROIC, and ROA for a comprehensive assessment of a company’s financial performance.
That may sound like a lot of work, but with the right tools, it can be much simpler.
Cube simplifies financial analysis by automating complex calculations like ROE and integrating seamlessly with your existing financial data. For FP&A professionals, this means streamlined data processing, accurate reports, and data-driven forecasting. To see for yourself, book a demo with Cube today.
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