Return On Average Equity (ROAE)

What Is Return On Average Equity (ROAE)

Return on average equity (ROAE) is a financial ratio that measures the performance of a company based on its average shareholders' equity outstanding. 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.

Understanding Return On Average Equity (ROAE)

The return on equity (ROE), a determinant of performance, is calculated by dividing net income by the ending shareholders' equity value in the balance sheet. This equity value can include last-minute stock sales, share buybacks, and dividend payments. This means that ROE may not accurately reflect a business' actual return over a period of time. The return on average 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. 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. Basically, instead of dividing net income by stockholders' equity, an analyst divides net income by the sum of the equity value at the beginning and end of the year, divided by 2.

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. If a business rarely experiences significant changes in its shareholders' equity, it is probably not necessary to use an average equity figure in the denominator of the calculation.

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 Interpretation

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, whether it is profitability, asset turnover, or leverage. The product of these three measurements 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.

ROAE 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 is due to growing sales and improved productivity instead of growing debt.