Return on Equity (ROE) is a financial ratio that shows the profit generated by a company in a year compared to the shareholder funds available.
It therefore shows how much profit (attributable to the shareholders) in dollars (or any other currency) can be distributed to the shareholders for every dollar of common stock.
Return on Equity Formula
The formula to calculate the return on equity ratio is very simple. You will need two numbers, the net income available for distribution to the shareholders which can be found on the income statement and the shareholders equity which can be found on the balance sheet – statement of financial position.
The formula is: ( Net Income/Common Stock Equity)%
It is worth pointing out that in order to calculate ROE, the net income is after deducting any dividend that needs to be paid out to investors that hold redeemable preference shares. However, these dividends are already deducted before arriving to the net income, since redeemable preference is debt and the “dividend” is included in the finance expense line (on the profit and loss statement).
Return on Equity Example
The following example will help us calculate and understand the return on equity ratio. It’s a straightforward scenario for two different companies that have a different capitalization and different income.
Company A has a lower net income but also a significantly lower equity. At the same time, Company B has a higher net income but a significantly higher shareholders’ equity figure.
Therefore, the return on equity ratio for company A (2,000,000/15,000,000) is 13% while the ROE for Company B is 10% (5,000,000/50,000,000).
Return on Equity Analysis and Interpretation
Based on the example above, we can see that while Company B has a higher net income, ROE takes into account the “size” of equity too.
As a result, ROE for company A is higher than for Company B. This means that Company A has managed to generate more profit per dollar of equity than Company B.
Investors usually follow company that have a high ROE because it shows that the company is able to potentially pay out high dividend. However, high ROE and does not necessarily mean high dividends too. In other words, a company might be able to generate high profits compared to the equity funds used, but it might be choosing to either retaining them or re-investing them instead of distributing them.
Another point that is worth noting is that ROE can be manipulated by raising debt instead of capital. If a company used more debt, then the shareholders’ equity will be lower and therefore the ROE (return on equity) will be higher. However, higher debt also means higher interest expense (among other things).
Finally, a variation of the Return on Equity is the Return on Common Equity which excluded preference shares (both the dividend paid to preference shares but also the funds raised by issuing preference shares).
Return on Equity Online Calculator
The online calculator below can be used to calculate the return on equity. Just fill in the blanks!