Return on equity (ROE) is a measure of financial performance calculated by dividing net income by shareholders’ equity. Because shareholders’ equity is equal to a company’s assets minus its debt, ROE is considered the return on net assets.
ROE is considered a gauge of a corporation’s profitability and how efficient it is in generating profits. The higher the ROE, the more efficient a company’s management is at generating income and growth from its equity financing.
ROE is expressed as a percentage and can be calculated for any company if net income and equity are both positive numbers. Net income is calculated before dividends paid to common shareholders and after dividends to preferred shareholders and interest to lenders.
Equation: Return on Equity = Net Income / Average Shareholders’ Equity
Relatively high or low ROE ratios will vary significantly from one industry group or sector to another. Still, a common shortcut for investors is to consider a return on equity near the long-term average of the S&P 500 (14%) as an acceptable ratio and anything less than 10% as poor.
Sustainable growth rates and dividend growth rates can be estimated using ROE, assuming that the ratio is roughly in line or just above its peer group average. Although there may be some challenges, ROE can be a good starting place for developing future estimates of a stock’s growth rate and the growth rate of its dividends. These two calculations are functions of each other and can be used to make an easier comparison between similar companies.
Note: Average Global ROE is 21.88%.
Sometimes an extremely high ROE is a good thing if net income is extremely large compared to equity because a company’s performance is so strong. However, an extremely high ROE is often due to a small equity account compared to net income, which indicates risk.