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Return On Equity

Return on equity (ROE) is a measure of financial performance calculated as net income divided by shareholder's equity. ROE measures the profitability of a company by revealing how much profit is generated with the shareholders' invested money. The DuPont formula breaks down ROE into its components of net profit margin, asset turnover, and accounting leverage to better understand changes in a company's ROE over time. ROE is used to compare performance of companies within an industry and is considered a good indicator if between 15-20%, though on its own does not predict stock value which depends on many other factors.

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69 views2 pages

Return On Equity

Return on equity (ROE) is a measure of financial performance calculated as net income divided by shareholder's equity. ROE measures the profitability of a company by revealing how much profit is generated with the shareholders' invested money. The DuPont formula breaks down ROE into its components of net profit margin, asset turnover, and accounting leverage to better understand changes in a company's ROE over time. ROE is used to compare performance of companies within an industry and is considered a good indicator if between 15-20%, though on its own does not predict stock value which depends on many other factors.

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Return on equity

The return on equity (ROE) is a measure of the profitability of a business in relation to the equity.
Because shareholder's equity can be calculated by taking all assets and subtracting all liabilities, ROE can
also be thought of as a return on assets minus liabilities. ROE measures how many dollars of profit are
generated for each dollar of shareholder's equity. ROE is a metric of how well the company utilizes its
equity to generate profits.

The formula
Net Income [1]
ROE = Average Shareholders' Equity

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] ROE is also a factor in stock valuation, in association
with other financial ratios. While higher ROE ought intuitively to imply higher stock prices, in reality,
predicting the stock value of a company based on its ROE is dependent on too many other factors to be of
use by itself.[3]

Sustainable growth
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).
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 decompose ROE into
three important components. Essentially, ROE will equal the net profit margin multiplied by asset turnover
multiplied by accounting leverage which is total assets divided by the total assets minus total liabilities.
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 accounting 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.
If the firm takes on too much debt, the cost of debt rises as creditors demand a higher risk premium, and
ROE decreases.[4] 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.[5]

See also
DuPont analysis
List of business and finance abbreviations
Return on assets (RoA)
Return on brand (ROB)
Return on capital employed (ROCE)
Return on capital (RoC)
Return on net assets (RoNA)
Leverage effect

Notes
1. http://www.investopedia.com/terms/r/returnonequity.asp Investopedia Return on Equity
2. "Profitability Indicator Ratios: Return On Equity (http://www.investopedia.com/university/ratio
s/profitability-indicator/ratio4.asp)", Richard Loth Investopedia
3. Rotblut, Charles; Investing, Intelligent (January 18, 2013). "Beware: Weak Link Between
Return On Equity And High Stock Price Returns" (https://www.forbes.com/sites/investor/201
3/01/18/beware-weak-link-between-return-on-equity-and-high-stock-price-returns/#b208ea5
69548). Forbes. Retrieved November 4, 2018.
4. Woolridge, J. Randall and Gray, Gary; Applied Principles of Finance (2006)
5. Bodie, Kane, Markus, "Investments"

External links
Annual Ratio Definitions (http://gold.globeinvestor.com/public/help/flat/help_financials_repor
t_ratios.html)
Return On Equity Screener (http://www.macroaxis.com/invest/ratio/Return_On_Equity?min=
10&max=20)- figures from financial statements
Online Return On Equity Calculator (http://www.investingcalculator.org/return-on-equity.html)
Return On Equity Explained (https://www.equitymaster.com/glossary/return-on-equity/)

Retrieved from "https://en.wikipedia.org/w/index.php?title=Return_on_equity&oldid=1164694114"

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