Return on equity (ROE) is a ratio that provides investors with insight into how efficiently a company (or more specifically, its management team) is handling the money that shareholders have contributed to it. In other words, it measures the profitability of a corporation in relation to stockholders’ equity. The higher the ROE, the more efficient a company's management is at generating income and growth from its equity financing.
ROE is often used to compare a company to its competitors and the overall market. The formula is especially beneficial when comparing firms of the same industry since it tends to give accurate indications of which companies are operating with greater financial efficiency and for the evaluation of nearly any company with primarily tangible rather than intangible assets.
Return On Equity (ROE)
This is the basic formula for calculating ROE is:
ROE=Shareholder EquityNet Income
The net income is the bottom-line profit—before common-stock dividends are paid—reported on a firm’s income statement. Free cash flow (FCF) is another form of profitability and can be used instead of net income.
Note that ROE is not to be confused with the return on total assets (ROTA). While it is also a profitability metric, ROTA is calculated by taking a company's earnings before interest and taxes (EBIT) and dividing it by the company's total assets.
ROE can also be calculated at different periods to compare its change in value over time. By comparing the change in ROE's growth rate from year to year or quarter to quarter, for example, investors can track changes in management's performance.
Putting It All Together
The ROE of the entire stock market as measured by the S&P 500 was 12.76% in the fourth quarter of 2019. A first, critical component of deciding how to invest involves comparing certain industrial sectors to the overall market.
For example, a look at ROE figures categorized by industry might show the stocks of the railroad sector performing very well compared to the market as a whole, with an ROE value of 25.8%, while the general utilities and retail sales sectors had of 8.63% and 11.52%, respectively. This could indicate that railroad companies have been a source of a steady growth industry and have provided excellent returns to investors.
The next step involves looking at individual companies to compare their ROEs with the market as a whole and with companies within their industry. For instance, at the end of FY 2019, Procter & Gamble (PG) reported a net income of $4 billion and total shareholders' equity of $47.6 billion. Thus, PG's ROE as of FY 2019 was:
$4 billion ÷ $47.6 billion = 8.4%
P&G's ROE was below the average ROE for the consumer goods sector of 11.31% at that time. In other words, for every dollar of shareholders' equity, P&G generated 8.4 cents in profit.
Not All ROEs Are the Same
Measuring a company's ROE performance against that of its sector can be more complicated than it seems, however.
For example, in the third quarter of 2019, Bank of America Corporation (BAC) had an ROE of 8.48%. According to the Federal Deposit Insurance Corporation (FDIC), the average ROE for the banking industry during the same period was 11.67%. In other words, Bank of America under-performed the industry.
However, the FDIC calculations deal with all banks, including commercial, consumer, and community banks. The ROE for commercial banks was 4.11% in the third quarter of 2019. Since Bank of America is, in part, a commercial lender, its ROE was above that of other commercial banks.
In short, it's not only important to compare the ROE of a company to the industry average but also to similar companies within that industry.
In evaluating companies, some investors use other measurements too, such as return on capital employed (ROCE) and return on operating capital (ROOC). Investors often use ROCE instead of the standard ROE when judging the longevity of a company. Generally speaking, both are more useful indicators for capital-intensive businesses, such as utilities or manufacturing.