Return on equity
What is Return on equity?
Return on equity compares profit attributable to common shareholders with the average common equity supporting that profit.
How it is calculated
A common formula divides annual net income available to common shareholders by average common shareholders' equity. Average beginning and ending equity is preferable to a single ending balance, and more frequent averages can help after major transactions. Ensure preferred claims and noncontrolling interests are treated consistently in both numerator and denominator.
What drives ROE
ROE can be decomposed into profit margin, asset turnover, and financial leverage, with more detailed versions separating tax and interest effects. This DuPont view distinguishes operating strength from balance-sheet amplification. Buybacks, dividends, impairments, and accumulated losses reduce book equity and can mechanically raise ROE even when business economics do not improve.
Example
A company earns $80 million attributable to common shareholders and has beginning equity of $760 million and ending equity of $840 million. Average equity is $800 million and ROE is 10%. If a debt-funded repurchase reduces average equity, ROE may rise despite unchanged operating profit, while financial risk also increases.
How to interpret it
Compare ROE with the required return on equity and with peers using similar leverage and accounting. Persistent high ROE supported by pricing power, asset efficiency, and reinvestment opportunities can create value. High ROE driven by leverage or a very small denominator is less reassuring. Examine incremental returns on retained earnings rather than relying only on the current average.
Limitations and edge cases
Book equity reflects historical accounting and may omit internally developed intangible value. Negative or near-zero equity makes ROE meaningless or extreme. Gains, write-downs, pensions, currency translation, and repurchases alter numerator or denominator. Banks use equity as a core operating resource, while other sectors may be better compared using return on invested capital alongside ROE.
Practical checklist
Use attributable common earnings and average common equity, identify negative or small denominators, and adjust periods for major transactions. Decompose margin, turnover, and leverage. Review buybacks, issuance, dividends, comprehensive income, goodwill, and impairments. Compare reported and normalized results through a cycle, then assess growth, reinvestment, capital adequacy, and whether returns exceed an appropriate cost of equity.
Also known as: ROE
Sources and further reading
- Introduction to Financial Statement Analysis, CFA Institute
- Conceptual Framework for Financial Reporting, IFRS Foundation