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Return on Equity – ROE Calculator

Written by:
PK

On this page is a Return on Equity or ROE calculator. Enter a company's net income and shareholders' equity, and the tool will return the realized ROE.

Return on Equity Calculator

What is ROE or Return on Equity?

Return on Equity – commonly known by its shorthand ROE – is the ratio of a business's net profit or income to shareholders' equity. As a measure of financial performance, it lets you see how well management's investments are performing relative to what they owe shareholders.

What is a good return on equity?

In short: the higher the ROE, the better, although a stable Return on Equity over roughly 10% is a great sign (where 10% is the rough average return on stock over time). As you'd expect, an increasing ROE is superior, but a slowly declining ROE in a more mature company is acceptable as long as it comes with stability.

Over a long enough period, a company's returns are constrained by its returns on equity (or possibly a closely related measure), not multiple expansion, or what investors are willing to pay per dollar of cash flow. Also, note the importance of stability; companies with stable and predictable returns on equity are bound to be less volatile.

Return on Equity Formula

The formula for Return on Equity (ROE) is

Return\ On\ Equity\ (ROE)=\frac{Net\ Income}{Shareholders'\ Equity}

Where:

  • Net Income – Net earnings remaining after deducting all costs, including line items (where applicable) such as taxes, interest, depreciation, and amortization.
  • Shareholders' Equity* – The amount remaining once debts are debited from the company's assets, sort of the "net worth" of the stock.

Where available, you really want to use average shareholder's equity, since the very process of earning increases equity. For example, to calculate an annual return on equity, average the shareholder's equity at the beginning of the year and reported at the end.

Limitations of ROE

ROE is an excellent measure, but it can be deceiving if you also don't check a company's leverage. Consider that while a company's debt increases, shareholder's equity will decrease – but as it's on the bottom of the equation, ROE will appear larger.

Additionally, there are two other ways shareholder's equity decreases – losses and (often) stock buybacks

Negative earnings will reduce a company's retained earnings, so if the company then turns it around you might have a few quarters of spectacular numbers – in those cases, turn to something like Return on Invested Capital, instead. 

Ditto for share buybacks. A company usually will hold repurchased shares in treasury stock – which is an asset to the company, but a debit from our side, as investors. Why's that? The company can resell those shares at any time – unless it chooses to retire the shares, which means they'll be wiped off the books.

A third, definitionally strange positive return on equity comes when a company loses money (negative earnings) and has negative shareholders' equity due to negative retained earnings or an entry in treasury stock. This strange situation means – you guessed it – unprofitable companies will sometimes have a positive ROE. 

In short, always check the tape, don't blindly trust a screen!

Negative Returns on Equity

Paradoxically, you'll find two types of companies with negative returns on equity due to technically having negative shareholders' equity:

  1. Profitable companies with past losses or a high balance of treasury stock.
  2. Unprofitable companies with positive earnings.

Like (famously) Autozone, the first types of companies are great at returning capital to shareholders by buying back stock. The second type might be turnaround plays or growth companies finally hitting profitability. Either way, check closely.

And, as mentioned above, two negatives make a positive – so watch out for losses from companies that have negative shareholders' equity and a positive ROE!

Using the ROE Calculator

The bottom line is that Return on Equity is a great quick check on a company's temperature, but has some flaws and gotchas that require you to look a bit deeper. A company's capitalization makes a huge difference to ROE, so make sure you know going in if a company you're looking at is more leveraged than its peers. And – heed my warning – always check the Return on Invested Capital and Return on Assets as well.

Other resources:

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