{{Short description|Measure of the profitability of a business}} The '''return on equity''' ('''ROE''') is a measure of the [[profitability]] of a business in relation to its [[Equity (finance)|equity]];<ref name="Fernando"/> where: :{{math|1=ROE = {{big|{{sfrac|Net Income|Average Shareholders' Equity}}}}}} <ref name="Fernando">Jason Fernando (2023). [http://www.investopedia.com/terms/r/returnonequity.asp "Return on Equity (ROE) Calculation and What It Means"], [[Investopedia]]</ref>
Thus, ROE is equal to a [[fiscal year]]'s [[net income]] (after [[preferred stock]] dividends, before [[common stock]] dividends), divided by total equity (excluding preferred shares), expressed as a percentage. Because shareholder's equity can be calculated by taking all assets and subtracting all liabilities, ROE can also be thought of as a return on [[Net asset value|NAV]], or ''assets less liabilities''.
==Usage== ROE measures how many dollars of profit are generated for each dollar of [[shareholder's equity]], and is thus a metric [[Financial ratio#Profitability ratios|of how well the company utilizes its equity]] to generate profits.
ROE is especially used for comparing the performance of companies in the same industry. As with [[return on capital]], an ROE is a measure of management's ability to generate income from the equity available to it. ROEs of 15–20% are generally considered good.<ref name="pedia"/>
ROE is also a factor in [[stock valuation]], in association with other [[financial ratio]]s. Note though that, while higher ROE ought intuitively to imply higher stock prices, in reality, predicting the stock value of a company based on its ROE is dependent on too many other factors to be of use by itself.<ref>{{Cite news | date = January 18, 2013 | last = Rotblut| first = Charles |last2 = Investing | first2 = Intelligent | url = https://www.forbes.com/sites/investor/2013/01/18/beware-weak-link-between-return-on-equity-and-high-stock-price-returns/#b208ea569548 | newspaper = Forbes | access-date = November 4, 2018| title = Beware: Weak Link Between Return On Equity And High Stock Price Returns}}</ref>
Both of these are expanded below. <!-- * The [[sustainable growth rate|sustainable growth model]] shows that when firms pay dividends, earnings growth lowers. If the dividend payout is 20%, the growth expected will be only 80% of the ROE rate. * The growth rate will be lower if earnings are used to buy back shares. If the shares are bought at a multiple of book value (a factor of ''[[Variable (mathematics)|x]]'' times book value), the incremental earnings returns will be reduced by that same factor (ROE/''x''). * ROE is calculated from the company perspective, on the company as a whole. Since much financial manipulation is accomplished with new share issues and buyback, the investor may have a different recalculated value 'per share' (earnings per share/book value per share). -->
==The DuPont formula== {{main|DuPont analysis}} {{further|DuPont analysis#ROE analysis|Financial risk management#Corporate finance}} The [[Du Pont identity|DuPont formula]], <ref name="Hargrave">Marshall Hargrave (2022). [https://www.investopedia.com/terms/d/dupontanalysis.asp Dupont Analysis], [[Investopedia]].</ref> also known as the strategic profit model, is a framework allowing management to decompose ROE into three ''actionable'' components; these "drivers of value" being the [[Economic_efficiency|efficiency]] of operations, asset usage, and finance. ROE is then the [[net profit margin]] multiplied by [[asset turnover]] multiplied by [[Leverage_(finance)#Investments|accounting leverage]]<!-- which is total assets divided by the total [[asset]]s minus total [[Liability (financial accounting)|liabilities]] -->:
:<math>\mathrm{ROE} = \frac{\mbox{Net income}}{\mbox{Sales}}\times\frac{\mbox{Sales}}{\mbox{Total Assets}}\times\frac{\mbox{Total Assets}}{\mbox{Shareholder Equity}}</math>
The application, in the main, is either to [[financial management]] or to [[fund management]]:
*Splitting return on equity into the three components, makes it easier for [[financial manager]]s to understand changes in ROE over time. For example, if the net margin increases, every sale brings in more money, resulting in a higher overall ROE. Similarly, if the asset turnover increases, the firm generates more sales for every unit of assets owned, again resulting in a higher overall ROE. Finally, increasing accounting leverage means that the firm uses more [[debt]] financing relative to [[Equity (finance)|equity]] financing. Interest payments to [[creditor]]s are [[tax deduction|tax-deductible]], but dividend payments to shareholders are not. Thus, a higher proportion of debt in the firm's capital structure leads to higher ROE.<ref name="pedia">Richard Loth [http://www.investopedia.com/university/ratios/profitability-indicator/ratio4.asp Profitability Indicator Ratios: Return On Equity]", [[Investopedia]]</ref> Financial leverage benefits diminish as the risk of defaulting on interest payments increases. If the firm takes on too much debt, the [[cost of debt]] rises as creditors demand a higher risk premium, and ROE decreases.<ref>Woolridge, J. Randall and Gray, Gary; Applied Principles of Finance (2006)</ref> Increased debt will make a positive contribution to a firm's ROE only if the matching [[return on assets]] (ROA) of that debt exceeds the interest rate on the debt.<ref>Bodie, Kane, Markus, "Investments"</ref>
*Identifying the sources of ROE in this fashion similarly allows [[investment analyst]]s a better knowledge of the company and how it should be [[valuation (finance)|valued]].<ref name="Fernando"/> Here, analysts will compare the current sources of ROE against the company's history and its competitors, and thereby better [[Valuation using discounted cash flows#Determine equity value|understand the drivers]] of value. In particular, as mentioned, ROE is used developing [[Sustainable_growth_rate#From_a_financial_perspective|estimates of a stock’s growth rate]], and hence the growth rate of its [[dividends]]. These then feed, respectively, into the [[terminal value (finance)|terminal value]] calculation, and / or the [[dividend discount model]] valuation result. Relatedly, within the [[listed company|listed corporate]], this analysis allows management to preempt any underperformance vs [[Capital asset pricing model#Asset-specific required return|shareholders' required return]],<ref>See discussion under § [https://www.oreilly.com/library/view/financial-accounting-in/9780470635292/ch05sec12.html Shareholder Value, ROE, and Cash Flow Analyses] in: Jamie Pratt and Michael Peters (2016). ''Financial Accounting in an Economic Context'' (10th Edition). Wiley Finance. {{ISBN|978-1-119-30616-0 }}</ref> which could then lead to a decline in the company's shares value, since, "in order to satisfy investors, a company should be able to generate a higher ROE than the return available from a lower risk investment".<ref>Staff (2023). [https://corporatefinanceinstitute.com/resources/accounting/what-is-return-on-equity-roe/ Return on Equity]. [[Corporate Finance Institute]]</ref>
==See also== *[[DuPont analysis]] *[[List of business and finance abbreviations]] *[[Return on assets]] (RoA) *[[Return on brand]] (ROB) *[[Return on capital employed]] (ROCE) *[[Return on capital]] (RoC) *[[Return on net assets]] (RoNA) *[[Leverage effect]]
==Notes== {{reflist}}
{{Financial ratios}}
[[Category:Financial ratios]] [[Category:Investment indicators]]