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Return on equity (ROE) is a ratio that provides investors with insight into how efficiently a company (or more specifically, its management team) is managing the equity that shareholders have contributed to the company. Below is some insight into how to calculate it.

Basic ROE

To get to the basic ROE formula, the numerator is net income, which is the bottom-line profits reported on a firm’s income statement. Free cash flow (FCF) is another form of profitability and can be used in lieu of net income.

The denominator for ROE is equity, or more specifically shareholders’ equity. Shareholders’ equity is assets minus liabilities on a firm’s balance sheet and is the accounting value that is left for shareholders should a company settle its liabilities with its reported assets.

ROE then becomes: Net income ÷ shareholders’ equity

Another Calculation for ROE

ROE can also be determined when knowing a firm’s dividend growth rate (g) and earnings retention rate (b). The calculation is as follows:

ROE = g ÷ b

The dividend growth rate can either be estimated by an analyst or an investor, or can be based on a historical dividend growth rate, such as over the past five years or decade. The earnings retention rate can also be a prospective or historical figure and is simply:

1 – dividend payout ratio.

The dividend payout ratio is the percentage of a firm’s net income (or free cash flow) paid out to shareholders as dividends.

Putting it all Together

The ROE of the entire market (as measured by the S&P 500) has averaged in the low to mid-teens in recent years and recently hovered around 12.5% in 2016. A critical component of looking at individual companies is to compare their ROEs with the market as a whole and other rivals.

For instance, at the end of fiscal year 2016, consumer product giant Procter & Gamble Co (PG) reported net income of $10.5 billion and total shareholders' equity of $57.34 billion. PG's ROE as of 2016 therefore is:

$10.5 billion ÷ $57.34 billion = 18.33% which exceeds the market’s level and the consumer goods industry average of just below 11% at that time.

This means that for every dollar of shareholders' equity, P&G generated 18 cents in profit i.e. common equity investors saw an 18.33% return on their investment.

The Bottom Line

ROE is one of the most important metrics for evaluating management effectiveness. There are a couple of key ways to calculate it and use it to compare a firm to its competitors and the market in general.

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