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Return On Equity: Assets Minus Liabilities. ROE Is A Measure of How Well A Company Uses Investments To

Return on equity (ROE) is a measure of how profitable a company is relative to its shareholder equity. It is calculated by taking a company's net income and dividing it by its total equity. ROEs of 15-20% are generally considered good. ROE is used to compare performance of companies in the same industry and is a factor in stock valuation. The DuPont formula breaks down ROE into its components of net profit margin, asset turnover, and financial leverage to better understand changes over time.

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57 views2 pages

Return On Equity: Assets Minus Liabilities. ROE Is A Measure of How Well A Company Uses Investments To

Return on equity (ROE) is a measure of how profitable a company is relative to its shareholder equity. It is calculated by taking a company's net income and dividing it by its total equity. ROEs of 15-20% are generally considered good. ROE is used to compare performance of companies in the same industry and is a factor in stock valuation. The DuPont formula breaks down ROE into its components of net profit margin, asset turnover, and financial leverage to better understand changes over time.

Uploaded by

Manoj Kumar
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Return on equity

From Wikipedia, the free encyclopedia

In corporate finance, the return on equity (ROE) is a measure of the profitability of a


business in relation to the book value of shareholder equity, also known as net assets or
assets minus liabilities. ROE is a measure of how well a company uses investments to
generate earnings growth.

Contents
1 The formula

2 Usage

3 ROE and sustainable growth

4 The DuPont formula

5 See also

6 Notes

7 External links

The formula
[1]

ROE is equal to a fiscal year net income (after preferred stock dividends, before common
stock dividends), divided by total equity (excluding preferred shares), expressed as a
percentage.

Usage
ROE is especially used for comparing the performance of companies in the same industry. As
with return on capital, a ROE is a measure of management's ability to generate income from
the equity available to it. ROEs of 15-20% are generally considered good.[2]

ROEs are also a factor in stock valuation, in association with other financial ratios. In
general, stock prices are influenced by earnings per share (EPS), so that stock of a company
with a 20% ROE will generally cost twice as much as one with a 10% ROE.[citation needed]

ROE and sustainable growth


The benefit of low ROEs comes from reinvesting earnings to aid company growth. The
benefit can also come as a dividend on common shares or as a combination of dividends and
company reinvestment. ROE is less relevant if earnings are not reinvested.[citation needed]

The sustainable growth model shows that when firms pay dividends, earnings growth
lowers. If the dividend payout is 20%, the growth expected will be only 80% of the
ROE rate.

The growth rate will be lower if earnings are used to buy back shares. If the shares are
bought at a multiple of book value (a factor of x times book value), the incremental
earnings returns will be reduced by that same factor (ROE/x).

New investments may not be as profitable as the existing business. Ask "what is the
company doing with its earnings?"

ROE is calculated from the company perspective, on the company as a whole. Since
much financial manipulation is accomplished with new share issues and buyback, the
investor may have a different recalculated value 'per share' (earnings per share/book
value per share).

The DuPont formula


The DuPont formula, also known as the strategic profit model, is a common way to break
down ROE into three important components. Essentially, ROE will equal the net profit
margin multiplied by asset turnover multiplied by financial leverage. Splitting return on
equity into three parts makes it easier to understand changes in ROE over time. For example,
if the net margin increases, every sale brings in more money, resulting in a higher overall
ROE. Similarly, if the asset turnover increases, the firm generates more sales for every unit of
assets owned, again resulting in a higher overall ROE. Finally, increasing financial leverage
means that the firm uses more debt financing relative to equity financing. Interest payments
to creditors are tax deductible, but dividend payments to shareholders are not. Thus, a higher
proportion of debt in the firm's capital structure leads to higher ROE.[2] Financial leverage
benefits diminish as the risk of defaulting on interest payments increases. So if the firm takes
on too much debt, the cost of debt rises as creditors demand a higher risk premium, and ROE
decreases.[3] Increased debt will make a positive contribution to a firm's ROE only if the
matching Return on assets (ROA) of that debt exceeds the interest rate on the debt.[4]

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