Return on Equity (ROE)

Return on Equity or ROE is a profitability ratio specially meant for the equity shareholders. It is expressed in percentage (net profit / shareholder’s fund * 100). ROE denotes the percentage return a shareholder earns on its invested capital.

ROE Formula

Return on Equity = Profit after Tax / Shareholder’s Equity * 100

Profit after Tax: The numerator is the profit considered after deducting the costs, depreciation, tax and dividends given to preference shareholders (but before deduction of dividends paid to common equity holders). ROE is also called RONW (Return on Net Worth) alternatively.

Shareholder’s Equity: Shareholder’s equity can be calculated in various ways. Firstly, average shareholder’s equity i.e. the average of the opening equity at the start of the financial period and closing equity at the end of the financial period. Secondly, if new shares are issued or shares are brought  Return on Equity (ROE)back during the year, the weighted average of the no. of shares and their respective investment value per share can be used.

Looking at the income statement of a company, assets of any company is financed by either debts or equity or a combination of both.  Thus,

Shareholder’s Equity = Assets – Debt

Thus, Return on Equity can also be expressed as Profit after Tax / (Total Assets – Debt) * 100.

Illustration Showing ROE Calculation

Below is a sample of financial figures for ABC Co. Ltd. for FY 2011-12. All figures in USD.

Net Profit after Tax   =    18,000
Shareholder’s Equity  =    60,000
Current Liabilities       =    10,000
Non-current Liabilities =    40,000
Total Assets             =    110,000
Return on Equity      =    18,000/60,000*100 or 18000/(110000 – 40000 – 10000)*100
=    30%

The above illustration demonstrates how return on equity is calculated. Here, for every dollar invested by investors in the equity of ABC Co. Ltd. It generates 30% return. This means for every dollar of invested amount, 30 cents of assets are created.

Interpretation and Uses of ROE

  • Return on equity is not only an indication of how well a company uses shareholder’s funds but it is also an overall sign of profitability.
  • ROE can be a great tool to compare companies within the same sector/industry.
  • A company is said to create value for shareholders if its ROE is greater than the cost of capital. If ROE is less than the cost of capital, the investors do not gain anything by investing in the company. On the other hand, there is always a risk of the company going bankrupt. Thus, any investor looking to invest in a company can use this ratio to analyse the estimated return.
  • Comparison of change in ROE from the beginning of the period to the end of the period can also be a good indicator for investors. Averaging ROE over a period to 5-10 years and comparing it with present ROE can indicate historical growth.

Caution While Using ROE Ratio

ROE, at times, can be a misleading figure. ROE can increase with a reduction in shareholder’s equity. If ROE increases due to a drop in equity which ultimately results in an increase in the debt the company takes, it will expose the company to a greater risk. For example, a company may issue buyback of its shares which may artificially boost ROE. Thus, investors need to exercise caution while using ROE ratio. In the case of buyback or issue of new shares, it is best to evaluate ROE along with EPS, which can give a clearer picture of earning from equity.

A more holistic version of ROE is the DuPont analysis, which gives the exact reason for a change in ROE value which can be calculated by the following formula i.e. Profit Margin x Asset Turnover x Equity Multiplier.

Last updated on : July 31st, 2017
What’s your view on this? Share it in comments below.

Leave a Reply

Current Ratio
  • How to Analyze (Interpret) and Improve Debt Service Coverage Ratio (DSCR)?
    How to Analyze (Interpret) and Improve Debt …
  • Limitations of Ratio Analysis
    Limitations of Ratio Analysis
  • Cash Ratio
    Cash Ratio
  • Types of Activity /Turnover Ratios
    Types of Activity / Turnover Ratios
  • Subscribe to Blog via Email

    Enter your email address to subscribe to this blog and receive notifications of new posts by email.

    Join 122 other subscribers

    Recent Posts

    Find us on Facebook

    Related pages

    three major theories of dividend policyadvantages and disadvantages of inventorygordon growth modelmerits and demerits of bankingwacc projectmaximizing shareholders wealthnet operating income theorynpv vs roiadvantages of continuous budgetingequity growth rate formulamethods of analyzing financial statementsfixed assets to long term liabilities ratiorecourse and nonrecoursewhat is the dividend discount modelirrevocable letters of creditdividends irrelevance theoryhow to calculate wacc of a companymeaning of leverage in financial managementdividend policy theory and practicestakeholder stockholderpure conglomerate mergerconversion price convertible bondwhat is the formula for quick ratiodebt management ratios formulaadvantages of issuing preferred stockdebt to profit ratiohow to calculate external funds neededcost of capital waccdisadvantages of financial accountingadvantages and disadvantages of withdrawalirr in financeus gaap capitalization rulesaverage rate of return method of capital budgetingmerger and consolidation definitioninvoice finance definitionconversion ratio convertible bondcalculate payback periodeps growth formulasemi fixed cost and semi variable costpayback period problems and solutionswhat is the eoq formulacalculating discounted paybackequation for inventory turnoverexample accounting equationtotal asset turnover ratio interpretationadvantages and disadvantages of abc costinghow to calculate degree of operating leveragewhat is the difference between a stockholder and a shareholderhow to calculate profit ratioadvantages and disadvantages of breakeven analysiswhat are the similarities between cost accounting and financial accountingdefinition of profit maximisationhindi meaning of liabilitywacc assumptionsprofitability index equationopportunity cost in capital budgetingus gaap leasesequipment lease purchase agreement templateadvantages and disadvantages of car leasingaged debtors analysishedging meaning in financecomputing waccparticipating convertible preferreddirect financing leasesexample of debenturegaap book valueworking capital in npvdefinition of bookeepingprice earnings ratio calculation formulameaning of irrevocable letter of creditdividend decision theoriesmeaning of explicit cost