How to Calculate Return on Equity (ROE)
Key takeaways
Return on equity (ROE) is designed to measure how much profit a company may earn for every dollar that their shareholders have invested in them.
There is a basic ROE calculation as well as a more advanced calculation option, which is often referred to as the DuPont formula or DuPont analysis.
ROE may provide different insights when compared to other measures of profitability, such as return on assets (ROA) or return on invested capital (ROIC).
What is return on equity (ROE)?
Return on equity (ROE) can be one way for investors to measure how much profit a company earns for every dollar their shareholders invested in the company’s stock.
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The return on equity formula
The basic ROE calculation
The following is typically used as the basic calculation for ROE:
Net income / shareholder equity = ROE
Advanced calculation: The 3-Step DuPont analysis
The DuPont formula or analysis may offer a more advanced calculation for ROE. It involves multiple calculations and steps, as detailed below:
- Net income / revenue = Net profit margin
- Sales / average total assets = Asset turnover (AT)
- Average total assets / average shareholder equity = Equity multiplier (EM)
- Net profit margin x asset turnover x equity multiplier = DuPont analysis
What is a "good" return on equity?
There may not be a specific ROE number that an investor would universally consider to be “good” for every company. However, it may often be helpful to look at various benchmarks in order to compare companies. The following benchmarks may be helpful for investors looking into ROE:
S&P 500 benchmarks
Companies on the S&P 500 may see approximately 13% ROE on average.
Industry-specific norms
ROE may also vary according to the industry that a company operates in. For instance, companies in the United States whose primary operations don’t center on financial services may see approximately 11% ROE on average.
Relative vs. absolute ROE
Generally speaking, relative ROE refers to the total gain or total loss of a stock. Absolute ROE generally compares the stock’s gain or loss to the performance of a benchmark, such as the S&P 500.
Limitations and "red flags" in ROE
The impact of high debt
ROE typically does not account for any debts a company may have. Generally, increasing the amount of debt can also decrease total shareholder equity. If a company has high levels of debt, or if they take on debt for share buybacks, that may make their ROE calculation appear higher.
Stock buybacks
When a company buys back its own shares, that generally reduces the available equity. In calculating ROE, that reduced amount of equity can make a company’s ROE appear to be higher.
Negative ROE
Negative ROE may mean that a company is experiencing a net loss. While each situation varies, this could signal the company may be going through financial issues or challenges.
ROE vs. other profitability metrics
ROE vs. ROA (Return on assets)
Return on assets (ROA) calculates a company’s profit generation based on its total assets, including debt and equity. ROE calculations, on the other hand, do not typically account for debt.
H3: ROE vs. ROIC (Return on invested capital)
Return on invested capital (ROIC) measures how a company earns profits based on its utilization of its debt and equity. ROIC also typically involves a company’s net operating profit after taxes (NOPAT) while ROE focuses on a company’s net income.
Bottom line
Calculating a company’s ROE may provide insights into how well that company can generate a profit based on the equity provided by its shareholders. It may be a helpful tool for investors comparing stock investment options across companies.
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Frequently asked questions
Can a company have a high ROE but be a bad investment?
A high ROE may not include other important considerations, such as a company’s debt load.
How does a stock buyback affect ROE?
A stock buyback may reduce a company’s equity while also raising its ROE.
Why is average equity used instead of year-end equity?
Equity may increase or decrease, so using year-end equity only when calculating ROE may not provide the most accurate insights. Average equity may provide a more accurate calculation when used within ROE calculations.
The above article is intended to provide generalized financial information designed to educate a broad segment of the public; it does not give personalized tax, investment, legal, or other business and professional advice. Before taking any action, you should always seek the assistance of a professional who knows your particular situation for advice on taxes, your investments, the law, or any other business and professional matters that affect you and/or your business.
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