Return on Equity (ROE)

It is a ratio that measures a company's profitability relative to shareholder equity.

Author: Isabel Lin
Isabel Lin
Isabel Lin
Isabel Lin is a Computer Science and Economics student at Brandeis University, set to graduate in 2026. At Wall Street Oasis, Isabel progressed from a Financial Research Intern to an Editor Specialist, demonstrating her ability to analyze and communicate complex financial information effectively. In addition to her academic and professional endeavors, Isabel has achieved notable success in athletics and music, being a U.S. Junior Olympic National Gymnast and a Carnegie Hall Pianist. These accomplishments reflect her discipline and versatility, which she brings to her work in financial markets and computing.
Reviewed By: Parul Gupta
Parul Gupta
Parul Gupta
Working as a Chief Editor, customer support, and content moderator at Wall Street Oasis.
Last Updated:March 3, 2024

What is Return on Equity (ROE)?

Return on Equity, or ROE, is a ratio that measures a company's profitability relative to shareholder equity, indicating how efficiently the company utilizes shareholder funds to generate profits.

To calculate, here is the formula: 

Return on Equity = Net Income / Average Total Shareholders’ Equity

This ratio indicates the company's profitability relative to the equity invested by shareholders.

Think of the return on equity as a tool to measure how smartly a company uses the money its owners have trusted it with to rake in profits. It's like a report card showing how effectively the company turns investor cash into earnings.

Why do people care? Well, if you've put money into a company, you want to know you're making a smart choice, right? 

Return on equity helps investors see if the company is a money-making champion or if it's lagging behind others. It's like a reality check against other companies, showing if your investment is doing as well as others.

Return on equity is super important for anyone putting money into a company. It's like a health check for investments, guiding investors to make clever decisions about where to put their cash for the best returns or if it's time to look for better opportunities elsewhere.

Key Takeaways

  • Return on Equity (ROE) measures a company's ability to generate profits from shareholders' equity and is calculated by dividing net income by average total shareholders' equity.
  • Stakeholders like investors, stockholders, analysts, creditors, lenders, and management use ROE to evaluate a company's profitability and financial performance.
  • High ROE signifies efficient profit generation, solid financial position, and potential competitive advantage when it exceeds industry averages.
  • Low ROE may indicate weak profitability, poor asset management, financial risks, or a less favorable competitive position.

Why is ROE Important?

Return on Equity is like a report card for a company's money-making skills, and many people check it out for various reasons. Here's who looks at it:

  1. Investors: Investors assess ROE to gauge how effectively a company generates profits with the funds provided by shareholders. By comparing ROE across companies, investors can identify opportunities for maximizing returns on their investments and make informed decisions about where to allocate their capital.
  2. Stockholders: These people own a piece of the company. They observe ROE to check if the company is using their money wisely. A favorable number might mean more profit for them through dividends or increased value of their shares. 
  3. Analysts and Money Experts: These pros dig deep into companies' numbers. They use this metric to see how well a company performs over time and compare it with other measures to get the whole picture of its health.
  4. Creditors and Lenders: Banks and big financial institutions want to know if the company makes enough profit to repay any borrowed money. A strong ROE suggests the company is in good shape to meet its debts.
  5. Management: The company's bosses use this number to check how their strategies are working. It's like their score in the game of business. They compare it with others in the industry to see if they're leading or lagging behind.

High ROE vs. Low ROE

Just like you need different study methods for different subjects, ROE should be compared with other companies in the same industry to understand how well it's really doing.

High ROE: Star Performer

A high ROE suggests the company efficiently turns invested money into profits. Here are a couple of reasons why a high number is favorable: 

  1. Making Big Bucks (Profitability): This is like the company hitting a home run in sales or cost-saving strategies. It's not just earning; it's earning a whole lot, thanks to great customers, smart pricing, and efficient operations.
  2. Smart Spending (Efficiency): A high ROE shows the company is like a smart student who knows exactly how to study to get the best grades. It means it's using its buildings, money, and resources in the smartest possible way to create profits.
  3. Solid and Secure (Financial Strength): Companies with high ROE are often financially stable and robust, much like having a healthy savings account. They have the resources to expand, innovate, or reward their investors.
  4. Leading the Pack (Competitive Advantage): Just as the top student in class sets the curve, a company with a high ROE often sets the pace in its industry. It might be due to superior products, better services, or just smarter ways of doing business.

Low ROE: Room for Improvement

Conversely, a low ROE is like receiving grades that show you need to buckle down and study harder. It signals that the company might not be using the invested money effectively. Here's what a low number can indicate:

  1. Limited Earnings (Profitability): Imagine the company's earnings are like a leaky bucket, not holding as much profit as they should. Perhaps the sales are sluggish, costs are sky-high, or the market's just not responding well.
  2. Unused Potential (Efficiency): A company with low ROE might be like a student with all the right books and tools but not using them effectively. It might have the technology, staff, and capital that aren't being utilized to their full potential, leading to wasted opportunities.
  3. Borrowed Trouble (Financial Risk): Much like a student who's overspent on credit, a company with high debt might struggle under the weight of its repayments, affecting its ability to profit and grow.
  4. Losing the Race (Competitive Position): A company with a low ROE might be losing its edge in the market. Maybe its products are outdated, or it's not innovating as fast as its competitors.

A high metric in this area is comparable to being an outstanding student, indicating that the company is proficient in generating and efficiently utilizing its funds. Conversely, a low figure in this measure suggests that the company has various areas needing enhancement.

Recognizing these areas is vital, allowing the company to address weaknesses, harness strengths, and ultimately, aim for that top spot in the business sector.

Return on Equity Formula

The formula for calculating return on equity is as follows:

Return on Equity = Net Income / Average Total Shareholders’ Equity

Let’s break it down further:

1. Net Income

It's the cash a company keeps after paying for everything. This amount is usually shown on a company's income statement. We calculate net income by subtracting revenue from expenses. 

2. Average Total Shareholders’ Equity

It's a measure of the company's worth to its owners, calculated by looking at the start and end values over a certain period.

The formula is simple: 

Average Total Shareholders’ Equity = (Beginning Shareholders’ Equity + Ending Shareholders’ Equity) / 2

Hold up? How do you calculate Beginning Shareholders' Equity or Ending Shareholders' Equity? Let us quickly show you how. 

First, calculate Beginner Shareholders’ Equity, which can be found in the balance sheet of the past year. We do Beginner Shareholders' Total Assets minus Beginning Total Liabilities. 

Then, calculate the Ending Shareholders’ Equity found in the current year's balance sheet. The formula to find Ending Shareholders’ Equity is 

Ending Total Assets - Ending Total Liabilities

Finally, calculate the average. The formula is: 

(Beginning Shareholders’ Equity + Ending Shareholders’ Equity) / 2

To compute return on equity, divide net income by the average total shareholders’ equity.

Note

All of this information can be found through Annual 10K reports filed through the United States Securities and Exchange Commission (SEC). 

Return on Equity Example

Let's say you're looking at Apple's 10K Annual Report from November 3, 2023. The numbers might look like this:

  • Net Income: $97.0 billion (That's how much they made after all expenses)
  • Beginning Shareholders' Equity: $50,672
  • Ending Shareholders' Equity: $62,146

1. Average Total Shareholders’ Equity

We find the Average Total Shareholders’ Equity by using the equation: 

(Beginning Shareholders’ Equity + Ending Shareholders’ Equity) / 2

This balance sheet gives us the Beginning Shareholders’ Equity and the Ending Shareholders’ Equity. We will use these numbers to find the Average Total Shareholders’ Equity. 

Beginning Shareholders' Equity = $352,755 -$302,083 = 50,672

= $50,672

Ending Shareholders' Equity= $352,583 - $290,437

= $62,146

Now, we can find the Average Total Shareholders’ Equity.

Average Total Shareholders' Equity= ($50,672 + $62,146)/2

= $56,409

2. Obtaining Return on Equity

We now have all the numbers to calculate return on equity.

Return On Equity = Net Income/Average Total Shareholders' Equity

= $99,803/ $56,409

= 1.76927440657 or 1.7693

 

Multiply by 100 to get the percentage.

Return On Equity = 176.93% 

Therefore, the return on equity is 176.93%, according to Apple Inc.’s 2023 10K Annual Report.

That means Apple is making a 176.93% return on the equity that shareholders invested. Pretty cool, right?

Remember, these numbers are just examples; real financial statements can be more complex. But this is how you calculate and understand the return on equity!

Return on Equity Vs. Other Ratios

Let's get into the world of finance by imagining we're running a lemonade stand. Just as you check various things to see how well your stand is doing, investors use ratios to check how well a company is doing. Let's look at these ratios as parts of our lemonade stand business:

1. Return on Assets (ROA)

Imagine all the stuff you've got for your lemonade stand — the stand, pitchers, lemons, sugar, cups — these are your assets. ROA is like a score that tells you how well you use all this stuff to make profitable lemonade. 

It's about efficiency: are you squeezing every penny of profit from each lemon and cup? 

By comparing ROA to ROE (the profit you make from the money you or others invested in the stand), you're asking, "Is all my equipment and ingredients working as hard as the money invested to make this stand profitable?"

2. Return on Investment (ROI)

This is about the allowance or money you spend to run your stand. Maybe you splurged on a bright sign or bought the fanciest lemons. 

ROI tells you if this was a smart move. It calculates the extra money you made compared to what you spent. This includes every penny spent or borrowed for the stand. 

When you compare ROI with ROE, you're figuring out if every dollar used, yours or borrowed, was worth it. It's like being a smart shopper and seller all in one, ensuring your lemonade stand isn't just popular but also a wise investment.

3. Gross Profit Margin

Here's where you become a savvy business kid. You know exactly how much you sell each cup of lemonade for and how much the ingredients cost. 

The gross profit margin is the money you have left after making each cup. It tells you how much you're earning after the costs of lemons and sugar. 

When you compare this with ROE, you're measuring how much your lemonade recipe earns for every investor dollar. It's about ensuring that your stand isn't just busy but also profitable per cup sold.

4. Return on Capital Employed (ROCE)

Now, imagine your stand has grown into a chain across the neighborhood. 

You've got money from investors and maybe a loan for more stands. ROCE looks at how well you use all that money to grow and profit. It's about leveraging every dollar, borrowed or given, to expand your lemonade empire. 

Comparing this with ROE is like assessing whether the money is being used wisely for growth or merely expanding without substantial profit.

5. Net Profit Margin

After a long day of selling, you count your earnings and then deduct the costs — lemons, sugar, cups, and perhaps wages if you hired a friend. What's left is your net profit. 

Net profit margin compares this final profit to your total sales. 

When you look at this alongside ROE, you assess your lemonade business's overall health and success. It's your end-of-day reality check, telling you exactly how much of your sales is genuine profit and how well the investment in your stand is paying off.

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