What is Return on Equity?

Return on equity can be thought of as investors’ bang for their buck…

A high ROE relative to its peers can mean that management of a company is doing an excellent job creating profits with the money shareholders have handed it, aka its existing assets minus its debt. This also helps us account for the size of different companies. If two companies have the same net income, the company that generated that income with less existing stockholder equity will have a higher return on equity ratio.

The equation for return on equity (ROE) is net income divided by shareholders’ equity. It’s typically expressed as a percentage, which you can find by multiplying the quotient (the result of the division) by 100.

Return on Equity = (Net Income / Shareholders’ Equity) * 100

Net income can be found on a company’s income statement. It’s sometimes called “after-tax profit”, “net earnings”, or “bottom line profit” – The latter of which has given rise to the expression “what’s the bottom line?” It often covers a one-year or one-quarter period.

Shareholders’ equity is found on the balance sheet, and it represents the owners’ claim on the assets of a company after liabilities have been paid. Shareholders’ equity tells you how much of the business the shareholders would be entitled to if the business liquidated its assets today. Since a company’s lenders are required to be repaid before shareholders can get paid, you subtract total liabilities from total assets to get the amount that is left to the shareholder.

The classic accounting equation that drives the balance sheet is:

• assets - liabilities = shareholders’ equity.

Because of this, shareholders’ equity can sometimes be referred to as net assets.

Because shareholders’ equity comes from the balance sheet, which represents a snapshot in time, you would actually need to use the average shareholders’ equity if you want to match the time period of the income statement. So if the income statement is for the period between January 1 and December 31 of last year, you would add the shareholders’ equity from the beginning and end of that period and divide it by two to get the average shareholders’ equity for the period.

The return on equity formula tells you how much bottom-line profit a business earns per dollar of shareholder equity. Naturally, investors want this number to be high.

Investors prefer a higher return on equity. In general, investors hope higher ROE is driven by increasing profits.

However, that's not the only way for return on equity to increase. The return on equity ratio is also determined by the denominator, shareholders’ equity. If shareholder’s equity goes down, return on equity can go up.

Since the account equation tells us that shareholders’ equity is calculated as assets minus liabilities, this means that shareholders’ equity will decrease if liabilities go up. For instance, if a company wanted to make its ROE increase, it could borrow money to buy back shares of its own stock. In this way, they would be raising liabilities and decreasing shareholders' equity, which would increase the ROE (assuming the net income stays the same).

If return on equity is negative, then either the business lost money during the period being looked at, or the business has more liabilities than it has assets.

In either case, a negative return on equity can be a sign of a potential issue. But it is not a helpful enough metric by itself. When you first look at it, you can’t be sure if it was negative because the company lost money or if it’s negative because of a negative value for shareholders’ equity.

In either situation, the business losing money or the presence of more liabilities than assets, ROE doesn’t add any useful information beyond those metrics themselves. To determine the root problem, you will need to look further into what is causing the ROE to be negative. For instance, if liabilities are currently high due to an aggressive short-term growth strategy, a negative ROE may be acceptable.

Deciding if a particular return on equity is good or bad requires context.

For instance, it doesn’t mean much to compare the ROE of Walmart and Facebook, since Walmart is a traditional retailer with physical locations, and Facebook is a social media company.

It would make more sense to compare Walmart to Amazon, another retailer, but even this comparison isn’t ideal. Amazon is primarily an online retailer. Although Walmart certainly has an online presence, its business was built on old fashioned brick and mortar stores.

A more useful comparison for Walmart might be the average ROE of the retail industry, the ROE of a close competitor like Target, or even Walmart itself in previous years.

A good benchmark for ROE is often the industry average. An ROE slightly higher than the industry average is high enough to show that the company is able to keep pace with competitors in its ability to generate net profits without being so high as to raise red flags.

A good return on equity will be relatively stable from one year to another, or better yet, increasing. But, with ROE, higher doesn’t always mean better. While a higher ROE can mean the company is more effective at turning shareholders’ equity into profit, there are some limitations to this ratio. We will look more closely at these limitations in the next section.

When evaluating a financial ratio and what it says about a business, it’s important to look at why the ratio is what it is (including the value of each component that makes up the ratio), because a ratio alone doesn’t tell you the whole story.

One of the significant blind spots of ROE is that it doesn’t offer much context about the company’s debt.

Since stockholders’ equity equals assets minus liabilities, an increase in liabilities means a decrease in stockholders’ equity. This means that management can make ROE look higher by shifting towards debt instead of equity in order to fund operations.

A rising return on equity that stems from management more efficiently generating profit from the company’s equity can be a positive thing, but a rising ROE can also come from the denominator of the equation (shareholders’ equity) shrinking, which can be risky.

Consider the following situations:

High ROE driven by increased debt: In the first, the company borrows money to buy back its own shares. In this situation, net income hasn’t necessarily changed, but earnings per share and return on equity both rise. The company hasn’t gotten any better at generating after-tax profit, it has simply shifted the source from which it funds its business.

High ROE driven by history of losses: For another example, let’s say that a company has gone through many years of realized losses which have diminished shareholders’ equity on the balance sheet. After several years of this trend, they finally have a year where they are profitable. Their ROE might end up being higher than their peers, but it’s not because they are more efficient at generating profits. It’s because their balance sheet has absorbed years of losses, making the shareholders’ equity really tiny.

Another limitation of ROE is that sometimes it can produce a negative number. This negative ROE can occur because the company had a loss during the period being examined or because the company has more total liabilities than assets. Either way, you can't tell why return on equity is negative without looking at its components separately.

And when ROE is negative, it is no longer a useful metric to compare against other companies.

Return on equity and return on assets are very similar. They are both financial ratios that combine the income statement and the balance sheet and use net income as the numerator. But they aren’t quite the same.

Return on assets is calculated by dividing the net income from the income statement by the total assets from the balance sheet. It tells you how much bottom-line, after-tax profit a business was able to generate for each dollar it possessed in assets.

Return on equity can be thought of as the return on net assets since it takes the net income number from the balance sheet and divides it by total assets minus total liabilities.

In the accounting formula that drives the balance sheet, assets minus liabilities are equal to shareholders’ equity, the denominator in the return on equity formula.

This means that if a company increases its debt, its ROE will increase relative to its ROA.

Return on invested capital (ROIC) is yet another financial ratio that combines the income statement and the balance sheet and is very similar to both ROA and ROE. The formula is:

(Net Income - Dividend) / (Debt + Equity)

While ROE seeks to give you bottom-line profit per dollar of net assets, return on invested capital seeks to show you how much the company is earning for the shareholders and debt holders.

This means that unlike both ROE and ROA, ROIC will usually use something different than net income as the numerator.

Often, the return on invested capital equation will use net operating profit after tax (NOPAT) instead of net income. NOPAT is calculated by taking operating income (aka “earnings before interest and taxes” or “EBIT”) and multiplying it by one minus the tax rate. Because this is a measure of profit that doesn’t subtract interest, it represents the return that the firm obtained for the equity holders and the debt holders.

The denominator of ROIC is debt plus equity, rather than just equity, like with ROE. This lets ROIC help give you a sense of how well the company is generating returns for both owners and lenders.

ROE can help you calculate the theoretical sustainable growth rate of the company. The formula is:

Sustainable Growth Rate = Return on Equity x (1 – Dividend Payout Ratio)

In other words, if you multiply the ROE by the percentage of profit the company reinvests (instead of paying out as a dividend). The metric can help offer some sense of how much the company can grow by relying on its own revenue, without borrowing money (there’s no guarantee that the company will achieve the estimated growth rate).

This calculation can help investors get a sense of what growth rate a company can achieve if it doesn’t change its dividend payment or borrow money.

Of course, the company could theoretically have the opportunity to grow more if it didn’t pay a dividend. But many investors would prefer the company to pay some dividend.