Return on equity (ROE) is a ratio that provides investors with insight into how efficiently a company (or more specifically, its management team) is handling the money that shareholders have contributed to it. In other words, it measures the profitability of a corporation in relation to stockholders’ equity. The higher the ROE, the more efficient a company's management is at generating income and growth from its equity financing.
Below are examples of how to calculate ROE.
The most basic formula to calculate ROE consists of inserting net income for a company as the numerator, which is the bottom-line profit (before common-stock dividends are paid) reported on a firm’s income statement. Free cash flow (FCF) is another form of profitability and can be used instead of net income.
The denominator for ROE is equity, or more specifically shareholders’ equity. Shareholders’ equity is assets minus liabilities on a firm’s balance sheet and is the accounting value that is left for shareholders should a company settle its liabilities with its reported assets.
As a result, ROE = net income ÷ shareholders’ equity
(Note: ROE is not to be confused with return on total assets (ROTA). While it is also a profitability metric, ROTA – as the name indicates – is calculated by taking a company's earnings before interest and taxes (EBIT) and dividing it by the company's total assets.)
Another Calculation for ROE
ROE can also be determined when knowing a firm’s dividend growth rate (g) and earnings retention rate (b). The calculation is as follows:
ROE = g ÷ b
The dividend growth rate can either be estimated by an analyst or an investor or can be based on a historical dividend growth rate, such as over the past five years or decade. The earnings retention rate can also be a prospective or historical figure and is:
1 – dividend payout ratio
The dividend payout ratio is the percentage of a firm’s net income (or free cash flow) paid out to shareholders as dividends.
Putting It All Together
The ROE of the entire stock market as measured by the S&P 500 has averaged in the low to mid-teens in recent years, and hovered around 11.5% in 2017. A first, critical component of deciding how to invest involves comparing certain industrial sectors to overall market. For example, a look at current ROE figures categorized by industry shows the stocks of the railroad sector performing very well compared to the market as a whole, with an ROE value of nearly 20%, substantially higher than the general utilities (7.5%) or retail sales (17%) sectors. In other words, railroad companies have been a source of steady growth industry, providing excellent returns to investors.
The next step involves looking at individual companies is to compare their ROEs with the market as a whole and with companies within their industry. For instance, at the end of the fiscal year 2017, Procter & Gamble (PG) reported net income of $10.10 billion and total shareholders' equity of $55.18 billion. PG's ROE as of 2017 therefore was:
$10.5 billion ÷ $55.18 billion = 18.30%
P&G's ROE exceeded the average ROE for the consumer goods sector of 10.5% at that time. In other words, for every dollar of shareholders' equity, P&G generated 18 cents in profit.
Not All ROEs Are the Same
Measuring a company's ROE performance against that of its sector can be more complicated than it seems, however.
For example, Bank of America Corporation (BAC) as of Q4 2017 posted an ROE of 6.83%. According to the FDIC, the average ROE for the banking industry during the same period was 5.24%. In other words, Bank of America outperformed the industry.
However, the FDIC calculations deal with all banks, including commercial, consumer, and community banks. The ROE for commercial banks was 7.56% in Q4 2017, according to the FDIC. And since Bank of America is in part, a commercial lender, its ROE was below that of other commercial banks.
In short, it's not only important to compare the ROE of a company to the industry average, but also to like companies within that industry.
In evaluating companies, some investors use other measurements too, such as return on capital employed (ROCE) and return on operating capital (ROOC). Investors often use ROCE instead of the standard ROE when judging the longevity of a company. Generally speaking, both are more useful indicators for capital-intensive businesses, such as utilities or manufacturing.
The Bottom Line
ROE is one of the most important metrics for evaluating management effectiveness and is often used to compare a company to its competitors and the overall market. Use of the ROE formula is especially beneficial when comparing firms of the same industry, since it tends to give accurate indications of which companies are operating with greater financial efficiency, and for the evaluation of nearly any company with primarily tangible rather than intangible assets. It's also good to consider an industry's sub-sectors, and make sure you're comparing corporations, you're truly comparing apples to apples – not just apples to other fruit.
ROE can also be calculated at different periods to compare its change in value over time. By comparing the change in ROE's growth rate from year to year or quarter to quarter, for example, investors can track changes in management's performance.