- Return on equity (ROE) is a financial performance metric that shows how profitable a company is.
- ROE is calculated by dividing a company's annual net income by its shareholders' equity.
- While useful, ROE can sometimes be misleading and can be distorted by dishonest accounting.
When analyzing stocks, some people look at technical factors like recent changes in the stock price. However, others prefer to dive into the financial performance of a company, known as fundamental investing.
One fundamental metric that investors might evaluate is return on equity (ROE), especially if you're a value investor, meaning you choose companies whose stock price seems to be undervalued in relation to their underlying finances.
While value investing involves looking at several factors, such as solid management and strong earnings, ROE is a more advanced metric that can help you see whether a company is generating a healthy amount of profit in relation to how much shareholders have invested.
What is return on equity (ROE)?
Return on equity (ROE) is a financial ratio that tells you how much net income a company generates per dollar of shareholders' equity, which is essentially the amount of invested capital from shareholders (not bondholders). It helps equity investors understand how efficiently a firm uses its invested money from shareholders to generate profit.
The ROE calculation excludes invested capital from bondholders, because those investors have a different type of stake in the company. There can be value in looking at return on total invested capital too, but it's different; a company might have a high return on total invested capital but that might only be possible because its debt to bondholders is so high, which would likely dampen the investment thesis for stock investors. So, equity investors can analyze a company's ROE over time and against industry averages to get a better sense of how well that company is doing vs. competitors.
Definition of key terms
Some key terms to understand as it relates to ROE include:
Net income: This means net profit, i.e., the profit after deducting all expenses, taxes, and any other costs incurred by the company. Net income is typically reported on a company's income statement.
Shareholders' equity: This is the claim shareholders have on a company's assets, after its debts are paid. It's calculated as Total Assets - Total Liabilities. Shareholders' equity is generally reported on a company's balance sheet.
Average shareholders' equity: This is simply the average value of shareholders' equity from the start of one period to the end of the other. Some ROE calculations use an average to help smooth out variance in shareholders' equity that can occur over time, such as if taking out a new loan significantly lowers shareholders' equity at a particular time.
Return on equity formula
To calculate ROE, divide a company's net annual income by its shareholders' equity. Multiply the result by 100 to get a percentage.
One way to obtain further insight into ROE is to break it down into components using a framework called the DuPont analysis. This more advanced analysis breaks ROE into three ratios, helping analysts understand how a company achieved its ROE, its strengths, and opportunities for improvement.
- The first ratio is net profit margin (net income divided by sales). A company can improve its profit margins by making more money on each unit it sells, such as by raising prices or lowering expenses.
- The second ratio is asset turnover (sales divided by total assets). A company can improve its asset turnover by increasing sales while keeping its total assets constant.
- The third ratio is financial leverage (total assets divided by shareholder equity). A company can improve its financial leverage ratio by generating more assets in relation to shareholder equity, e.g., finding ways to increase income without taking on more debt.
Increasing any of these ratios increases ROE. "Two firms can have the same ROE and get there in completely different ways," says Dr. Robert R. Johnson, professor of finance at Creighton University's Heider College of Business.
Example of ROE
For example, according to Meta's SEC filings, its net income for 2023 was about $39.1 billion. Total shareholders' equity was about $153.2 billion.
Facebook's ROE = $39.1 billion / $153.2 billion = 0.255 x 100 = 25.5%
That means that its annual net income is about 25.5% of its shareholders' equity.
How to calculate ROE in Excel or Google Sheets
To calculate ROE in Excel or Google Sheets, input a company's annual net income in cell A2. Then input the value of their shareholders' equity in cell B2. In cell C2, enter the formula: =A2/B2*100. The resulting figure will be the ROE expressed as a percentage.
Interpreting ROE
ROE is often a useful metric for evaluating a company's financial performance, but it's hard to judge in a vacuum.
Higher ROE is generally better
In general, a higher ROE is better than a low or negative number. A higher ROE signals that a company efficiently uses its shareholder's equity to generate income. Low ROE means that the company earns relatively little compared to its shareholder's equity. However, a good ROE is often context-dependent.
What is a good ROE?
A good ROE varies based on what you're comparing. In some industries, firms have more assets — and higher incomes — than in others, so ROE varies widely by sector. For example, 2024 data published by New York University puts the average ROE for the farming/agriculture industry at 27.51%. But it's only 3.25% in the advertising industry.
Also, factors like company size and broader economic conditions can affect ROE, so that's why it's helpful to benchmark ROE against peers.
That said, a high and stable ROE is generally better, but the absolute number should be considered in the context of the industry. It's also a good sign if ROE increases over time.
"While a company's absolute ROE is important, the change in ROE over time — and what drove the change — may be even more relevant," says JP Tremblay, teaching professor of finance in the Daniels College of Business at the University of Denver.
ROE can also be negative, which usually is a bad sign, but it's possible some accounting practices distort the number. For example, that doesn't necessarily mean the company has a negative cash flow. As Johnson notes, "companies that are losing money on an accrual accounting basis may have a negative ROE but a positive cash flow."
That said, negative ROE typically warrants further investigation.
Why ROE is important
ROE doesn't give you all the information you need to know about a company's financial position, but it can be part of the story. Here's why it's important to different stakeholders:
Investors
For investors, evaluating ROE can help you determine whether the company is putting equity capital to good use. If ROE is high and stable, that could be a clue that the company can continue to deliver solid earnings in the future, without having to take on unnecessary debt. That said, past performance is not a guarantee of future performance.
In contrast, a low or negative ROE could signal that the company is having trouble generating income in relation to the value of its assets and liabilities. If you're comparing two real estate companies with substantial assets, you'd perhaps expect them both to generate substantial income. But if one isn't, that could signal trouble ahead.
Also, an unusual or extremely high ROE can prompt an investor to do more research, such as because:
- It may signal negative net income. If a company posts both negative income and negative equity, it could result in a misleadingly high ROE. An analyst would want to check that net income and shareholders' equity are positive when interpreting ROE.
- It may signal profit inconsistencies. Suppose a company recorded years of losses against its shareholders' equity. One year with a large net income and artificially low shareholder equity could result in an extremely high ROE. When ROE is sky-high, most analysts would do some digging to check the company's income history.
- It may signal excess debt. Johnson notes that one easy — but risky — way for a profitable company to increase ROE is to borrow money. This is known as leverage. "Leverage works when you can make more money on borrowed money than it costs you," Johnson says. "Of course, leverage is often called a double-edged sword because it can magnify losses when you make less money (or lose money) on borrowed funds than they cost you."
Management
A company's management team can also use ROE to assess financial performance over time and find ways to improve. For example, ROE can indicate the rate at which a company can grow without having to borrow additional money. So, if ROE is consistently higher than peers, that might sway management away from issuing new bonds and perhaps trying to self-fund expansion through earnings or selling more shares.
ROE vs. ROA vs. ROIC
ROE tells investors how much income a company generates from a dollar of shareholder equity. It has some similarities to other profitability metrics like return on assets or return on invested capital, but it is calculated differently.
Return on assets (ROA) tells you how much of a company's profit is being driven by fixed investments like property and equipment. The formula for ROA is almost the same as ROE, but it uses total assets in the denominator whereas ROE uses shareholders' equity.
Return on invested capital (ROIC) also measures profitability relative to investment, but it adds a little more complexity: It tells you how much in net income (after paying dividends) a company generates from all its capital — both debt and equity. ROIC is calculated using net income less dividends in the numerator and the sum of a company's debt and equity in the denominator.
Each of these metrics is used to evaluate and compare companies based on how efficiently their management uses financial resources to generate profit, but each takes a different angle.
Limitations of ROE
While it's one of the most important financial indicators to stock investors, ROE doesn't always tell the whole story.
For example, it can be misleadingly low for new companies, where there's a large need for capital when income may not be very high. Similarly, some factors, like taking on excess debt, can lead to increased revenue that inflates a company's ROE, but it can also mean adding significant risk that's not reflected in the ROE number.
Some other limitations include:
Accounting practices
Another limitation of ROE is that it can be intentionally distorted using accounting loopholes or might simply differ based on different accounting practices. For example, a company that accounts for revenue on an accrual basis might have a different ROE than if it accounted for revenue on a cash basis, even though the long-term revenue is the same.
Short-term focus
Even when ROE is calculated using an average of shareholders' equity over a given period, such as a year, the formula still leans toward a short-term focus typically. In reality, the long-term profitability or sustainability of an investment might take several years if not decades to become clear.
Overall, ROE often provides useful clues about a company's financial performance, which can be useful for analyzing ROE for investment decisions or management choices. However, it's just one data point. It might be considered alongside other metrics like ROA and ROIC, among others.
FAQs about return on equity
Is ROE the same as ROA?
No, ROE is not the same as ROA. ROE measures profitability in relation to shareholders' equity, while ROA measures profitability in relation to total assets. ROA does not tell you anything about a company's debt, while ROE factors this in.
Can a negative ROE be good?
No, typically a negative ROE is not good, as it indicates the company is losing money. However, it's possible for ROE to be negative temporarily due to issues like a large one-time expense, but that does not necessarily mean the company is in trouble.
Where can I find a company's ROE?
You can find a company's ROE by calculating it yourself or on stock websites. For public companies, ROE can be calculated on your own by looking at net income on an income statement and shareholders' equity on a balance sheet, and you can also often find this metric published on stock websites. However, this information may not be available for privately owned companies.
