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What is return on equity?
Return on equity (ROE), also known as return on common equity (ROCE), is a measure of a business’s profitability. Specifically, it is a ratio describing the rate of profit growth a business generates for shareholders and owners. Investors and managers use ROE to compare the growth rates of different companies, or of a company and an industry benchmark.
ROE is a key metric for public companies, as it provide a simple metric to show how they use investors’ funds to drive earnings growth. ROE is also frequently used to set targets for executive compensation, as it incentivizes management to pursue profit growth. There are several ways to calculate return on equity:
ROE = net income / shareholders’ equity x 100
ROE = net income / revenue x revenue / total assets x total assets / shareholder equity
In the top equation, shareholders’ equity represents a company’s assets minus its liabilities, or the value owners or shareholders would receive if the company were to liquidate. If a company issues both preferred and common stock, only the common stock investment is counted for the purposes of ROE.
The second formula is called the DuPont equation, which breaks down the ROE formula into separate components to help managers understand changes in their ROE over time. The first part is equal to the profit margin, the second part measures how efficiently assets are used to generate sales, and the third part is a proxy for how much debt the company uses to drive growth.
Return on equity and return on assets (ROA) are distinct ratios for measuring the performance of companies. Whereas ROE helps investors understand the growth they get from an equity investment in a company, ROA helps them gauge how the company is utilizing its assets to generate growth. Return on investment (ROI) is a similar metric to ROE, although it considers the rate of growth of any sort of investment, rather than just an investment in a company.
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Return on equity example
Bud is researching potential investments for his boss, Gordon. He is looking into companies in the organic produce line, with an eye to capitalizing on the kale craze: Fruit Land and Vegetable Village. The companies have varying rates of EPS and revenue growth, which are due in part to a highly seasonal business, so Bud compares their ROEs to clear away the noise. Fruit Land has an ROE of 11 percent and Vegetable Village has one of 7 percent, providing one strong indication that Fruit Land may be the better investment. Most S&P 500 companies have a ROE between 10 and 15 percent.