Loading the player...
A:

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.

RELATED FAQS
  1. What is the average return on equity for a company in the financial services sector?

    Learn the importance of calculating a company's return on equity and what businesses in the financial services industry average ... Read Answer >>
  2. What is the average return on equity for a company in the oil & gas drilling sector?

    Investing in the oil and gas drilling sector can be a profitable endeavor for some investors, but it is first necessary to ... Read Answer >>
  3. What is the average return on equity for a company in the forest products sector?

    Investing in the forestry sector can provide a hedge against other asset classes, but investors should be aware of the sector's ... Read Answer >>
  4. How do you determine a tangible asset's useful life?

    Learn what the average return on equity for a company in the chemicals sector is and what factors influence changes in the ... Read Answer >>
  5. What is the average return on equity for a company in the utilities sector?

    Learn specifics about the utilities sector, how return on equity is determined and what the average ROE is for the utilities ... Read Answer >>
  6. What is the average return on equity for a company in the internet sector?

    Find out more about return on equity (ROE), how it is calculated and what the average ROE is for a company in the Internet ... Read Answer >>
Related Articles
  1. Investing

    How Return On Equity Can Help You Find Profitable Stocks

    It pays to invest in companies that generate profits more efficiently than their rivals. This is where ROE comes in.
  2. Investing

    Analyzing BP's Return on Equity (ROE)

    Examine the return on equity (ROE) for British Petroleum, the slumping international energy company that seems to be falling behind its competitors.
  3. Investing

    Analyzing JetBlue's Return on Equity (JBLU)

    Learn about JetBlue's historical ROE and how it stacks up to similar-sized peers. ROE is a useful metric for investors to understand.
  4. Investing

    High Return On Equity Businesses

    Companies with high returns on equity usually see an increasing stock price in the future.
  5. Investing

    Analyzing Google's Return on Equity (ROE) (GOOGL)

    Learn about Alphabet's return on equity. How has its ROE changed over time, how does it compare to its peers and what factors are driving ROE for the company?
  6. Investing

    Decoding DuPont Analysis

    Get a deeper understanding of ROE with these three-step and five-step calculations.
  7. Investing

    ROA And ROE Give Clear Picture Of Corporate Health

    Both measure performance, but sometimes they tell a very different story. This is why they’re best used together.
  8. Investing

    Analyzing Amazon's Return on Equity (ROE) (AMZN)

    Learn how to analyze Amazon's return on equity (ROE), especially given the company's focus on capital investments, as opposed to short-term earnings.
  9. Investing

    Analyzing Wells Fargo's Return on Equity (WFC)

    Examine Wells Fargo & Company's return on equity and how stacks up against its major competitors, along with future projections for the company's ROE.
RELATED TERMS
  1. Equity Multiplier

    The ratio of a company’s total assets to its stockholder’s equity. ...
  2. Return

    The gain or loss of a security in a particular period. The return ...
  3. Equity

    Equity is the value of an asset less the value of all liabilities ...
  4. Average Return

    The simple mathematical average of a series of returns generated ...
  5. Leverage Ratio

    A leverage ratio is any one of several financial measurements ...
  6. Shareholder Value

    The value delivered to shareholders because of management's ability ...
Hot Definitions
  1. Covariance

    A measure of the degree to which returns on two risky assets move in tandem. A positive covariance means that asset returns ...
  2. Liquid Asset

    An asset that can be converted into cash quickly and with minimal impact to the price received. Liquid assets are generally ...
  3. Nostro Account

    A bank account held in a foreign country by a domestic bank, denominated in the currency of that country. Nostro accounts ...
  4. Retirement Planning

    Retirement planning is the process of determining retirement income goals and the actions and decisions necessary to achieve ...
  5. Drawdown

    The peak-to-trough decline during a specific record period of an investment, fund or commodity. A drawdown is usually quoted ...
  6. Inverse Transaction

    A transaction that can cancel out a forward contract that has the same value date.
Trading Center