# Return on equity

Last updated

In corporate finance, the return on equity (ROE) is a measure of the profitability of a business in relation to the equity, also known as net assets or assets minus liabilities. ROE is a measure of how well a company uses investments to generate earnings growth.

Corporate finance is an area of finance that deals with sources of funding, the capital structure of corporations, the actions that managers take to increase the value of the firm to the shareholders, and the tools and analysis used to allocate financial resources. The primary goal of corporate finance is to maximize or increase shareholder value. Although it is in principle different from managerial finance which studies the financial management of all firms, rather than corporations alone, the main concepts in the study of corporate finance are applicable to the financial problems of all kinds of firms.

In accounting, equity is the difference between the value of the assets and the value of the liabilities of something owned. It is governed by the following equation:

## The formula

${\displaystyle ROE={\frac {\text{Net Income}}{\text{ Equity}}}}$ [1]

ROE is equal to a fiscal year net income (after preferred stock dividends, before common stock dividends), divided by total equity (excluding preferred shares), expressed as a percentage.

A fiscal year is the period used by governments for accounting and budget purposes, which varies between countries. It is also used for financial reporting by business and other organizations. Laws in many jurisdictions require company financial reports to be prepared and published on an annual basis, but generally do not require the reporting period to align with the calendar year. Taxation laws generally require accounting records to be maintained and taxes calculated on an annual basis, which usually corresponds to the fiscal year used for government purposes. The calculation of tax on an annual basis is especially relevant for direct taxation, such as income tax. Many annual government fees—such as Council rates, licence fees, etc.—are also levied on a fiscal year basis, while others are charged on an anniversary basis.

In business and accounting, net income is an entity's income minus cost of goods sold, expenses and taxes for an accounting period. It is computed as the residual of all revenues and gains over all expenses and losses for the period, and has also been defined as the net increase in shareholders' equity that results from a company's operations. In the context of the presentation of financial statements, the IFRS Foundation defines net income as synonymous with profit and loss. The difference between revenue and the cost of making a product or providing a service, before deducting overheads, payroll, taxation, and interest payments. This is different from operating profit.

Preferred stock is a form of stock which may have any combination of features not possessed by common stock including properties of both an equity and a debt instrument, and is generally considered a hybrid instrument. Preferred stocks are senior to common stock, but subordinate to bonds in terms of claim and may have priority over common stock in the payment of dividends and upon liquidation. Terms of the preferred stock are described in the issuing company's articles of association or articles of incorporation.

## Usage

ROE is especially used for comparing the performance of companies in the same industry. As with return on capital, a 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. [2] ROE is also a factor in stock valuation, in association with other financial ratios. 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. [3]

Return on capital (ROC), or return on invested capital (ROIC), is a ratio used in finance, valuation and accounting, as a measure of the profitability and value-creating potential of companies after taking into account the amount of initial capital invested. The ratio is calculated by dividing the after-tax operating income (NOPAT) by the book value of both debt and equity capital less cash/equivalents.

In financial markets, stock valuation is the method of calculating theoretical values of companies and their stocks. The main use of these methods is to predict future market prices, or more generally, potential market prices, and thus to profit from price movement – stocks that are judged undervalued are bought, while stocks that are judged overvalued are sold, in the expectation that undervalued stocks will overall rise in value, while overvalued stocks will generally decrease in value.

A financial ratio or accounting ratio is a relative magnitude of two selected numerical values taken from an enterprise's financial statements. Often used in accounting, there are many standard ratios used to try to evaluate the overall financial condition of a corporation or other organization. Financial ratios may be used by managers within a firm, by current and potential shareholders (owners) of a firm, and by a firm's creditors. Financial analysts use financial ratios to compare the strengths and weaknesses in various companies. If shares in a company are traded in a financial market, the market price of the shares is used in certain financial ratios.

## Sustainable growth

The benefit of low ROEs comes from reinvesting earnings to aid company growth. The benefit can also come as a dividend on common shares or as a combination of dividends and company reinvestment. [4]

• The 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 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).

According to PIMS, an important lever of business success is growth. Among 37 variables, growth is mentioned as one of the most important variables for success: market share, market growth, marketing expense to sales ratio or a strong market position.

In elementary mathematics, a variable is a symbol, commonly a single letter, that represents a number, called the value of the variable, which is either arbitrary, not fully specified, or unknown. Making algebraic computations with variables as if they were explicit numbers allows one to solve a range of problems in a single computation. A typical example is the quadratic formula, which allows one to solve every quadratic equation by simply substituting the numeric values of the coefficients of the given equation for the variables that represent them.

## The DuPont formula

The DuPont formula, also known as the strategic profit model, is a common way to decompose ROE into three important components. Essentially, ROE will equal the net profit margin multiplied by asset turnover multiplied by financial leverage. Splitting return on equity into three parts makes it easier 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 financial leverage means that the firm uses more debt financing relative to equity financing. Interest payments to creditors are 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. [2] 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. [5] 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. [6]

Asset turnover (ATO) or asset turns is a financial ratio that measures the efficiency of a company's use of its assets in generating sales revenue or sales income to the company.

Debt is when something, usually money, is owed by one party, the borrower or debtor, to a second party, the lender or creditor. Debt is a deferred payment, or series of payments, that is owed in the future, which is what differentiates it from an immediate purchase. The debt may be owed by sovereign state or country, local government, company, or an individual. Commercial debt is generally subject to contractual terms regarding the amount and timing of repayments of principal and interest. Loans, bonds, notes, and mortgages are all types of debt. The term can also be used metaphorically to cover moral obligations and other interactions not based on economic value. For example, in Western cultures, a person who has been helped by a second person is sometimes said to owe a "debt of gratitude" to the second person.

The return on assets (ROA) shows the percentage of how profitable a company's assets are in generating revenue.

${\displaystyle \mathrm {ROE} ={\frac {\mbox{Net income}}{\mbox{Sales}}}\times {\frac {\mbox{Sales}}{\mbox{Total Assets}}}\times {\frac {\mbox{Total Assets}}{\mbox{Shareholder Equity}}}}$