Financial Ratios And Profitability · Intermediate · 8 minute read · No ads
Return on Equity (ROE) Ratio
Also called ROE, return on common equity, return on shareholders’ equity
Return on equity measures net income relative to average shareholders’ equity. A company earning $120 million on average equity of $800 million has a 15 percent ROE. It can show profitable use of shareholder capital, but leverage and buybacks can lift the ratio without improving the underlying business.
Key takeaways
- ROE equals net income divided by average shareholders’ equity, usually expressed as a percentage.
- Use average equity when possible because the income statement covers a period while the balance sheet reports a point in time.
- A high ROE can reflect strong operations, financial leverage, a reduced equity base after buybacks, or a combination of these.
- Compare ROE with similar companies and review margins, asset efficiency, debt and cash flow before judging quality.
What is return on equity?
Return on equity measures how much net income a company produces relative to shareholders’ equity. It is a profitability ratio, usually calculated with average equity for the period.
ROE can help compare similar companies, but debt, losses, buybacks and very small or negative equity can make the number misleading.
How Return on Equity (ROE) Ratio works
| Step | What happens |
|---|---|
| 01 · Choose the earnings figure | Start with net income available to common shareholders for the period. |
| 02 · Calculate average common equity | Add opening and closing common equity, then divide by two. Use more frequent averages after major changes. |
| 03 · Divide and convert to a percentage | Divide earnings by average equity and multiply by 100. |
| 04 · Explain the drivers | Compare margins, asset turnover, leverage, buybacks and one time items with peers and prior periods. |
The formula
ROE = Net income available to common shareholders ÷ Average common shareholders’ equity × 100
Net income available to common shareholders is profit after expenses, interest, taxes and preferred dividends where relevant. Average common equity is usually beginning equity plus ending equity divided by two. Multiply the decimal result by 100.
A return on equity example with numbers
A company reports $120 million of net income available to common shareholders. Common equity was $760 million at the start of the year and $840 million at year end.
Average common equity is ($760 million + $840 million) ÷ 2 = $800 million. ROE is $120 million ÷ $800 million × 100 = 15 percent.
Now suppose the company uses debt financed buybacks to reduce average equity to $600 million while net income stays at $120 million. ROE rises to 20 percent, even though profit did not improve. The higher ratio must be interpreted with the added debt and reduced equity base.
Why it matters
ROE links the income statement with the balance sheet and asks how much profit the company generated for each dollar of shareholder equity. It is useful when comparing mature companies with similar accounting and capital needs.
Use the US Stock Screener with AI to compare return on equity with debt and valuation filters. For the bigger picture, the US Stock Screener can help you compare peers before opening their financial statements.
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Why average equity is usually better
Net income accumulates across a quarter or year, while shareholders’ equity is measured on specific balance sheet dates. Averaging opening and closing equity better matches the period covered by earnings. A more detailed analyst can use quarterly averages when the equity base changed sharply.
What can drive a high ROE
ROE can rise because profit margins improved, assets produced more revenue, or the company used more financial leverage. The DuPont framework separates those drivers into net margin, asset turnover and an equity multiplier. That makes it easier to see whether operating performance or financing choices drove the result.
How debt and buybacks can distort ROE
Borrowing can increase assets without the same increase in common equity. Buybacks also reduce the equity base. Both can lift ROE even when net income is unchanged, while also increasing financial risk. Review debt, interest coverage and cash flow rather than treating a higher ratio as automatically better.
When ROE stops being useful
A loss produces a negative numerator, and negative equity produces a denominator that can make the sign or percentage economically confusing. Very small equity can create an extreme number. In these cases, examine operating margins, return on assets, return on invested capital and cash flow instead.
Comparison
| Ratio | Basic formula | Best use |
|---|---|---|
| Return on equity | Net income ÷ average common equity | Profitability from the perspective of common shareholders |
| Return on assets | Net income ÷ average total assets | How efficiently assets produce profit |
| Return on invested capital | After tax operating profit ÷ invested capital | Operating return earned for debt and equity capital providers |
Check yourself
A company earns $90 million and has average common equity of $600 million. What is its ROE?
$90 million divided by $600 million equals 0.15. Multiplying by 100 gives a 15 percent return on equity.
Show the answer
15 percent
Things people get wrong
Mistake 01 Using only year end equity
A point in time denominator may not represent the capital employed across the earnings period.
Mistake 02 Assuming high ROE always means a strong business
Debt or buybacks can shrink equity and lift ROE without higher profit.
Mistake 03 Using ROE when equity is negative
The resulting percentage can be mathematically correct but economically misleading.
Questions people ask about Return on Equity (ROE) Ratio
How do you calculate return on equity?
Divide net income available to common shareholders by average common shareholders’ equity and multiply by 100.
What is a good ROE?
There is no universal threshold. Compare companies in the same industry and review the source and consistency of the return.
Why use average equity in ROE?
Net income covers a period, so averaging opening and closing equity better matches the denominator with the earnings period.
Can debt increase ROE?
Yes. Debt can reduce the proportion of assets funded by equity and can raise ROE, while also increasing interest and financial risk.
How do buybacks affect ROE?
Buybacks reduce common equity. If earnings do not fall proportionally, ROE can rise.
What does negative ROE mean?
It often reflects a net loss, negative equity, or both. Inspect the underlying numbers because the percentage can be hard to interpret.
What is the difference between ROE and ROIC?
ROE focuses on common shareholders’ equity. ROIC looks at operating returns generated from both debt and equity capital.
The bottom line
ROE shows how much accounting profit a company produced relative to shareholder equity. Use average equity, compare similar businesses and investigate the drivers. A durable ROE supported by margins, asset efficiency and cash flow is more informative than a high number created mainly by leverage or a reduced equity base.
Sources
- SEC, A Beginner’s Guide to Financial Statements
- Aswath Damodaran, Financial Measures and Ratios
- Aswath Damodaran, Accounting Statements
- Aswath Damodaran, Return on Equity by Sector
- Aswath Damodaran, Growth and Return on Equity
How we produced the figuresThe first example averages opening and closing equity: ($760 million + $840 million) ÷ 2 = $800 million. $120 million ÷ $800 million = 15 percent. The second scenario holds net income constant and reduces average equity to show why capital structure matters.
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About this page. Written by Associate Professor Charles Lo, CPA, PhD and edited by Felix La Spina. Checked against reliable sources before publication. No ads and no paywall. Editorial standards · How we fact check · Corrections log · Report an error
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