.webp)
“Focus on return on equity, not earnings per share”
Warren Buffet
Investors often cite return on equity (ROE) as one of the first metrics they look at when evaluating a stock. But why? Let’s dive into what ROE is, how it’s calculated, and why it’s so important. Follow along by calculating ROE yourself and exploring industry benchmarks using our free Return on Equity Calculator template.
What is return on equity?
Return on equity (ROE) is a financial metric used to measure the profitability of a business. It measures a company’s net income relative to total shareholder equity, or how much net income is generated per dollar of invested capital. ROE is typically measured as a percentage.
How do you calculate return on equity?
The formula for ROE is straight-forward - simply divide the company’s net income by its average shareholders’ equity.
- Net Income is a business’ bottom-line profit, or total revenue remaining after subtracting all business expenses. Dividend costs should not be included in net income calculations calculations
- Shareholder equity is equal to total assets minus liabilities
Why does return on equity matter?
Return on equity illustrates how effective a company is at managing shareholder capital. The higher a company’s ROE, the more efficient that business is at generating income with equity financing. ROEs vary based on industry, so the metric means little in isolation. Investors will often benchmark a company’s ROE against other businesses in the industry, or against industry averages, when evaluating a company’s financial performance.
What is a good return on equity?
In general, an ROE of 15-20% or greater is considered good.
However, the threshold for ‘good’ ROE varies by industry. Businesses in certain sectors inherently have greater assets and higher incomes than others, which is why ROE is most effectively used when evaluating companies in the same sector. More detail can be found in our free Return on Equity Calculator template, which includes average ROE by industry from 2016-2021.
Learn how Ramp strengthens your finances
FAQ
Net income is found on a company’s income statement, while shareholder equity is found on the balance sheet. These statements are often used together in a three-statement model.
There are several ways a company can increase their return on equity, but the most common methods include increasing financial leverage, increasing profit margins, and deploying idle cash to reduce assets.
Generally, the higher a company’s return on equity the better, as it demonstrates effective use of shareholder capital. However, a company’s return on equitybeing significantly higher than other companies in the same industry can also be a sign of increasing debt and inconsistent returns. Investors will often want to see return on equity that is marginally better than peer companies, but not excessively so.
Discover corporate and business credit cards
