Learn how to calculate ROE and analyze the results.
What Is the Return on Equity Ratio?
Return on equity is a way of measuring what a company does with investors’ money. It compares the total profits of a company to the total amount of equity financing that the company has received. In other words, the ROE ratio tells investors how much profit the company has generated for every dollar they invested. This type of measurement, comparing profits within a specific context, is known as a profitability ratio. It measures the performance of a company in terms of profits. Profitability ratios help to compare companies in the same industry, which are likely to have similar overhead costs and market conditions.
How Do You Calculate the Return on Equity Ratio?
To calculate the return on equity ratio, simply divide the net income (usually measured on an annual basis) by the company’s shareholders’ equity.
How Does the Return on Equity Ratio Work?
To better understand the return on equity ratio, it may be helpful to refresh yourself on what equity is. Equity refers to the ownership interest of investors in a business firm. Equity ownership in the firm means that the original business owner no longer owns 100% of the firm, but shares ownership with others. Many businesses finance themselves with equity, which means they sell part of the company (such as by issuing stock shares) to other people who want to become investors. The business receives money to finance its operations, and the investors receive partial ownership in the company (with the hopes that the company will grow in the future). On a company’s balance sheet, equity is represented by common stock, preferred stock, paid-in capital, and retained earnings. Total equity can be calculated by subtracting total liabilities from total assets.
The DuPont Method
While the ROE can be quickly calculated using the formula above, there’s another method of assessment that attempts to add some detail to the company’s financial outlook. This strategy was introduced by the DuPont Corporation in the 1920s, so it has become known as the “DuPont method,” the “DuPont model,” or “DuPont analysis.“ Instead of broadly comparing net income to shareholders’ equity, this model gets more specific by comparing three separate financial ratios. They are:
Asset turnoverThe net profit marginThe equity multiplier
Multiplying these three ratios gives you the ROE as measured by the DuPont method. This allows business owners to pinpoint the source of a company’s ROE and make more specific comparisons to competitors.
Limitations of the Return on Equity Ratio
ROE is a useful profitability ratio, but it shouldn’t be the only ratio used in analysis. Another helpful profitability ratio is the return on assets (ROA). ROA tells business owners how efficient a business is at turning assets into profits, not just equity. It’s calculated by dividing a company’s net income by its average assets. Both the ROE and ROA broadly assess a company’s profitability, but it won’t tell you specifically which aspects of the company are profitable and which aren’t. Efficiency ratios give analysts a better sense of how effectively a company spends its resources, manages inventory levels, and reduces overhead costs.
