What is 'Return On Average Equity - ROAE'
Return on average equity (ROAE) is an adjusted version of the return on equity (ROE) measure of company profitability, in which the denominator, shareholders' equity, is changed to average shareholders' equity. Typically, ROAE refers to a company's performance over a fiscal year, so the ROAE numerator is net income and the denominator is computed as the sum of the equity value at the beginning and end of the year, divided by 2.
BREAKING DOWN 'Return On Average Equity - ROAE'One of the most important determinants of performance is return. ROAE is the same as ROE, except instead of dividing net income by stockholders' equity, the analyst divides net income by an average of stockholders' equity. ROAE can give a more accurate depiction of a company's corporate profitability, especially if the value of the shareholders' equity has changed considerably during a fiscal year.
In situations where the shareholders' equity does not change or changes by very little during a fiscal year, the ROE and ROAE numbers should be identical, or at least similar.
ROAE is calculated by dividing net income by average equity. Net income is found on the income statement in the annual report. Stockholders' equity is found at the bottom of the balance sheet in the annual report. The income statement captures transactions from the entire year, whereas the balance sheet is a snapshot in time. As a result, analysts divide net income by an average of the beginning and end of the time period for balance sheet line items.
A high ROAE means a company is creating more income for each dollar of stockholders' equity. It also tells the analyst about which levers the company is pulling to achieve higher returns: profitability, asset turnover or leverage. The product of these three measures equals ROAE. The profit margin provides information about operating efficiency and is calculated by dividing net income by sales. The average asset turnover is a measure of asset efficiency and is calculated by dividing sales by the average total assets. The financial leverage, measured as the average assets divided by the average stockholders' equity, is a measure of the firm's debt level.
The ratio is driven by profitability, operating efficiency and debt. Leverage increases ROAE without increasing net income. As a result, it is important for analysts to confirm high ROAE measures with other return ratios to ensure a growing ROAE isn't due to growing debt instead of growing sales and improved productivity.