Return on equity (ROE)

Shareholders' equity is what would remain for the owners if the company sold its assets at book value and paid off every debt: the money shareholders put in plus the profits the company kept over the years, minus any shares it repurchased.

ROE divides the year's net income by that equity. An ROE of 15% means the company earned 15 cents of profit for every dollar of equity.

Net income comes from the income statement and covers a whole year, while equity comes from the balance sheet on a single date. Many analysts therefore divide by the average of the opening and closing equity, so that a large change during the year does not distort the result. If the company has preferred shares, their dividends are subtracted from net income and their value from equity, so that ROE describes the common shareholders only.

A company earns $120 million of net income in a year. Its equity was $900 million at the start of the year and $1,100 million at the end, so average equity is $1,000 million. ROE is 120 ÷ 1,000 = 12%.

Measured against the closing equity alone, the same profit gives 120 ÷ 1,100, about 10.9%. The choice of denominator matters, so when comparing ROE from different sources it helps to check which one was used.

• A figure around 15% or more is often described as strong, and a figure under 10% as modest, but these are rules of thumb rather than a standard.
• A useful benchmark is the return shareholders could expect elsewhere for similar risk, often put at 8% to 10% a year. A company whose ROE stays below that for years earns less on retained profits than its owners could earn on their own.
• Industries differ. Software and consumer brands need little equity and often show high ROE, while utilities and banks usually report lower figures. Comparing a company with its own sector says more than a single cutoff.
• Stability matters as much as the level. An ROE that holds steady over a full business cycle tells more than one strong year.

The DuPont analysis splits ROE into three parts, each answering a separate question: how much profit the company keeps from each dollar of sales, how much it sells for each dollar of assets, and how much of those assets are financed by the owners rather than by creditors.

Suppose the company in the example has $1,500 million of revenue and $3,000 million of assets. Its net margin is 8%, asset turnover is 0.5 and the equity multiplier is 3, and 8% × 0.5 × 3 gives the same 12%. Two companies with equal ROE can get there in very different ways: one through wide margins, the other through heavy borrowing.

Because equity is only the part of the business the owners finance, replacing equity with debt raises ROE even when the business itself earns no more.

Say the company borrows $400 million and spends it on repurchasing its own shares. Equity falls to about $600 million, and after-tax interest of $20 million cuts net income to $100 million. ROE rises to 100 ÷ 600, about 16.7%, although profit went down and the company now owes more.

ROIC avoids this by measuring the return on all the capital in the business, debt included. Reading the two side by side shows whether a high ROE comes from the operations or from the balance sheet.

• Negative or very small equity makes ROE meaningless. Companies that have repurchased many shares or run up large losses can show an ROE of hundreds of percent, or a negative equity that turns the sign around.
• One-off gains and losses, such as the sale of a business or a large write-down, move net income for a single year and with it ROE.
• Equity is recorded at book value. A company that grew through acquisitions carries goodwill on its balance sheet, while one that built its brand itself does not, so the same business can show different ROE.
• A high ROE says nothing about the share price. A company with excellent returns can still be priced well above what those returns justify.

• Net income available to common shareholders for the latest completed fiscal year, divided by the average of common equity at the start and the end of that year, from the company's annual reports filed with the SEC.
• If common equity was zero or negative at either date, ROE is shown as unavailable rather than as a misleading percentage.
• On the company page ROE is compared with sector peers next to ROIC and operating margin, as part of business quality; a higher value ranks better.
• ROE also applies to banks and insurers, where ROIC and the current ratio are left out.