Return on equity (ROE)
Are you searching for an answer to the question what is ROE? A return on equity definition is useful to investors because ROE represents a measurement of a company’s ability to return profits on the equity investments it receives from its shareholders. It is a ratio that investors can use to compare firms operating within the same industry to assess which one presents better investment opportunities.
Where have you heard about return on equity?
You will likely have come across ROE (return on equity) in media coverage of a company’s balance sheets in their earnings results. It is also used in analysis of stocks as a measure of their performance as investments.
What do you need to know about return on equity?
Return on equity is calculated as a percentage. The higher the percentage, the more income the company is generating from the equities it has issued. Measured over time, the ROE calculation shows how a company’s income from its equity financing has grown. A high return on equity gives a company ample funds to reinvest in the growth of the business. Return on equity for companies that perform well is typically around 15-20 per cent.
Return on equity as a metric is not necessarily the same as return on investment (ROI). The ROE is focused on the return on a company’s stock, while ROI is a broader measure that covers all of the company’s investments.
The return on equity (ROE) formula is straightforward – it is net income divided by shareholder equity and multiplied by 100. Shareholder equity is calculated by subtracting the liabilities from the assets on a company’s balance sheet.-1_1.png "ROE formula")
Comparing ROE for different companies in the same industry helps investors to see which ones have generated the highest rate of return. ROE is a useful metric for service-based businesses. For capital-intensive businesses that require a larger investment in assets, like those in manufacturing, return on capital employed (ROCE) is a more useful measure, as it takes into account their capital expenditure.
DuPont Model
The DuPont Model, or DuPont Analysis, is a return on equity example that was developed in the 1920s by chemicals manufacturer DuPont Corporation, to further analyse its performance. The model breaks down the equation further into three separate elements – net profit margin, total asset turnover and financial leverage.-2_1.png "ROE, Net Income, Sales, Total Assets, Average Shareholder Equit")
The net profit margin indicates how effective a company is in pricing its products and managing costs. The total asset turnover shows how effective the company is in using its assets to generate revenues. And financial leverage indicates how much debt the company is using to operate.
An extended DuPont formula breaks out net income into earnings before interest and tax (EBIT) in the first step and adds an interest expense divided by assets calculation.
By splitting ROE into parts, investors can analyse the different components that generate a company’s return to see if there are parts of the business that are performing well or underperforming relative to the others and compared to the competition.