Return on Equity

Definition of Return on Equity

The term “Return on Equity” or ROE refers to the profitability metric that helps in assessing a company’s ability to generate profits by leveraging the investments made by the shareholders of the company. In other words, ROE indicates the dollar profit generated by each dollar of common stockholders’ equity. Further, ROE can be seen as the amalgamation of two financial statements – net income and dividend paid to preference shareholders from the income statement and shareholder’s equity from the balance sheet.

ROE can be used as an industry benchmark, and a company with a relatively higher ROE than its industry peers can be considered to have a competitive advantage. Additionally, ROE can offer insights into a company’s financial management or its ability to grown business by leveraging equity.

Formula:

The formula for return on equity can be derived by dividing the difference between net income and dividend paid to preference shares by the average value of shareholder’s equity. The value of ROE is expressed in terms of percentage.

Mathematically, it is represented as:

Examples of Return on Equity (With Excel Template)

Let’s take an example to understand the calculation of Return on Equity in a better manner.

Example #1

Let us take the example of a company and explain how to compute return on equity (ROE). During 2018, the company booked a net income of $25 million, out of which $2.5 million has been paid to the preference shareholders in the form of dividends. Further, the company infused equity of $15.0 million in the middle of the year to total $75.0 million. Calculate the ROE of the company based on the given information.

Solution:

Equity at the Start of the Year is calculated using the formula given below

Equity at the Start of the Year = Equity at the End of the Year – Equity Infused – (Net Income – Preferred Dividend)

• Equity at the Start of the Year = $75.00 million – $15.00 million – ($25.00 million – $2.50 million)
• Equity at the Start of the Year = $37.50 million

Average Shareholder’s Equity is calculated using the formula given below:

Average Shareholder’s Equity = (Equity at the Start of the Year + Equity at the End of the Year) / 2

• Average Shareholder’s Equity = ($37.50 million + $75.00 million) / 2
• Average Shareholder’s Equity = $56.25 million

(ROE) is calculated using the formula given below:

ROE = (Net Income – Preferred Dividend) / Average Shareholder’s Equity

• (ROE) = ($25.00 million – $2.50 million) / $56.25 million
• (ROE) = 40.0%

Therefore, the company generated a profit at an ROE of 40.0% during the year 2018.

Example #2

Let us take the example of Apple Inc. to illustrate the computation of ROE. According to the annual report, the company generated a net income of $59.53 billion during 2018. Further, the value of shareholder’s equity at the start and at the end of the period was $134.05 billion and $107.15 billion. Calculate the ROE of Apple Inc. based on the given information.

Solution:

Average Shareholder’s Equity is calculated using the formula given below

Average Shareholder’s Equity = (Equity at the Start of the Year + Equity at the End of the Year) / 2

• Average Shareholder’s Equity = ($134.05 billion + $107.15 billion) / 2
• Average Shareholder’s Equity = $120.60 billion

Return on Equity (ROE) is calculated using the formula given below:

ROE = (Net Income – Preferred Dividend) / Average Shareholder’s Equity

• Return on Equity (ROE) = ($59.53 billion – 0) / $120.60 billion
• Return on Equity (ROE) = 49.36%

Therefore, Apple Inc.’s ROE stood at 49.36% for the year 2018.

Source Link: Apple Inc. Balance Sheet

Example #3

Let us take the example of Walmart Inc. to illustrate the computation of ROE. During 2018, the company made a net income of $10.52 billion. The year started with shareholder’s equity of $80.54 billion, while it ended with $80.82 billion. Calculate the ROE of Walmart Inc. based on the given information.

Solution:

Average Shareholder’s Equity is calculated using the formula given below:

Average Shareholder’s Equity = (Equity at the Start of the Year + Equity at the End of the Year) / 2

• Average Shareholder’s Equity = ($80.54 billion + $80.82 billion) / 2
• Average Shareholder’s Equity = $80.68 billion

Return on Equity (ROE) is calculated using the formula given below:

ROE = (Net Income – Preferred Dividend) / Average Shareholder’s Equity

• Return on Equity (ROE) = ($10.52 billion – 0) / $80.68 billion
• Return on Equity (ROE) = 13.04%

Therefore, Walmart Inc.’s ROE stood at 13.04% for the year 2018.

Source Link: Walmart Inc. Balance Sheet

Advantages of Return on Equity (ROE)

Some of the major advantages of return on equity are:

• It categorically outlines the percentage return earned by the equity shareholders.
• It helps investors in comparing the performance of different equity investments and thereby influence their future investment strategy.

Limitations of Return on Equity (ROE)

Some of the major limitations of return on equity are:

• It can be misleading in the case of new companies where the capital requirement is high in the initial days resulting in lower ROE.
• The ROE can be manipulated using various accounting caveats like increasing the project life, decreasing depreciation rate, etc.

Conclusion

So, the ROE is one of the major return metrics used by the equity investors as it captures the quality of the investment validated through actual figures. However, it is important that, as an investor, one can read between the lines of financial items so that they don’t end up being misled by the ROE per se.

1. Return on Total Assets
2. Equity Shares vs Preference Shares
3. Equity Examples
4. Equity Ratio