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Return on Equity Ratio


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Examples

Example 1:

Calculate annual RoE for Jensen Analytical Chemicals, when:

  • Annual net (after-tax) income = $1,722,000
  • Shareholder equity (start date) = $14,587,000 and.
  • Shareholder equity (end date ) = $16,332,000
  • Average shareholder equity = (shareholder equity on start date + shareholder equity at end date) ÷ 2 = ( $14,587,000 + $16,332,000 ) ÷ 2 = $15,459,500
  • Return on equity = annual net income ÷ average shareholder equity = $1,722,000 ÷ $15,459,500 = 0.11 = 11%

Example 2:

Calculate RoE of Rehmer Software, when:

  • Total assets = $2,342,000
  • Total liabilities = $1,383,000
  • Annual net profit = $242,000
  • Increase of shareholder equity = $302,000
  • Beginning shareholder equity = total assets – total liabilities = $2,342,000 − $1,383,000 = $959,000
  • Ending shareholder equity = beginning shareholder equity + shareholder equity increase = $959,000 + $302,000 = $1,261,000
  • Average shareholder equity = (Shareholder equity on start date + Shareholder equity at end date) ÷ 2 = ($959,000 + $1,261,000 ) ÷ 2 = $1,110,000
  • Return on equity = annual net income ÷ average shareholder equity = $242,000 ÷ $1,110,000 ≈ 0.22 = 22%

Return on Equity Ratio Definition

This ratio is an important measure of a company’s profitability. RoE (also known as return on capital) is the ratio of annual net income of a business to its stockholder equity. RoE measures total net income for a reporting period as a percentage of the total value of shareholder investment.

Investors and analysts use RoE to compare company performance. As with many financial ratios, however, RoE is best used to compare companies in the same industry. However, high RoE alone yields no immediate benefit. The benefit comes from the earnings reinvested in the company at a high RoE rate. This in turn gives a company a high growth rate. RoE is irrelevant if earnings are not reinvested.

NOTES:

  • Net income is after-tax income.
  • Average shareholder equity is calculated by dividing the sum of shareholders' equity at the beginning and at the end of the year by 2.
  • Net income values are obtained from income statements. Shareholder equity is found on balance sheets.
  • Calculating average shareholder equity requires year-end balance sheets of two consecutive financial years.

Analysis

Higher RoE values are generally favorable. That is, higher RoE values suggest a company is more efficient in generating income on new investments.

Investors should compare the ROE of different companies and check the trend in RoE over time. However, relying solely on ROE for investment decisions is not a safe bet because it can be artificially influenced by company managers.